Transfer pricing
Assume i do tax return, My sister comes to me and tells me i want to do the tax return. Assume that im very busy and that i operate at full capacity. I work many hours as i can and do tax return for 100 $ for every tax return. What would be my response to her?
In order to take her tax return i have to take one less tax return so i can do her tax return. What would be my minimum return for her ? 100 $ as my profits would go down if i dont do this.
What if i dont operate at full capacity? What would be my minimum price to charge my sister?
Incremental variable cost for doing tax return would be the one to charge her.
Scenario one
I operate at full capacity and after doing the tax return i have to return the tax return to them and acquire the tax return of 10$
Now that operate at full capacity what would be the minimum price to charge sister , therefore it would be 90 $ . What if im operating at capacity , my sister goes to some other tax person and can get it for 50 $ , what would be best for family. She wouldn’t be happy with me but what would be best for the family? Let her get the thing done for 50 $ and let me charge the other 90 $ for my other customer . Thats the definition of transfer price. The transfer price is price one division charge to the other division
If you are being evaluated on some measure of profitability you would want to maximize revenues and minimize expenses.
The selling division would want to charge the highest price since it is a revenue to them and higher profits
Buying division want to pay the lowest price since it is an expense to them and this results in higher profits
Transfer price is the price charged when one segment of a company provides goods or services to another segment of company. In practice , three general approaches are used in setting transfer prices
> Set transfer price at cost using
a) VMOH ( DL + DM + VOH)
b) Full absorbtion cost ( DL +DM +VMOH+FMOH)
c) set transfer price at market price
d) Set transfer price at negotiated market price
The need for transfer price?
> Responsability centres in decentralized operations often exchange products ( Responsability centres buy sell from to each other )
> Transfer price becomes expense to buying division and revenue to the selling division
> If divisions are measured on profitability, such return on investment then transfer price can have an impact on the performance of each division bonus. The higher the transfer price , other things equal , the more profitable will be the selling division and the less profitable will be the buying division.
> Choice of transfer price can be complicated by the fact that each division may be supplying portions of its output to outside customers as well as to sister divisions
> Often leads to heated disputes between responsibility centre managers : yet some transfer price must be established to evaluate the performance of the various parts of divisions of a company.
> Transfer pricing policy should allow divisional autonomy yet encourage managers to pursue corporate goals consistent with their own goals ( Goal congruence).f The reporting system must motivate responsibility centre management to pursue their own self interest which is conductive to the success of the company as a whole.
> The value placed on transfer goods and services is used to make it possible to transfer goods and services between divisions while allowing them to retain their autonomy. Transfer price can be a device to motivate managers to act in the best interest of the company.
Impact of transfer pricing of transferring divisions and company as a whole
| S division seller | B division buyer |
| Produces componenet and sells to be at tp of 30 $ unit | Purchases the component at transfer price of 30 $ per unit |
| Transfer pice and revenue to s | Transfer price 30$ and expense to b |
| Increase revenue and net income , increase ROI and the bonus | Decrease ROI and the bonus |
| Transfer price revenue = | Transfer cost |
Zero impact for buyer and seller for the company in general
Transfer Price should satisfy
a) Accurate performance evaluation
b) Goal congruence
c) Preservation of divisional autonomy
The minimum TP that would leave the selling division no worse off if internal transfer takes place. At this price, the selling division is indifferent between selling internally or externally as profit remains the same
The maximum TP would leave the buying division no worse off if internal transfer price takes place. At this price the buying division is indifferent between buying internally or externally as Profits remain the same
Note that it doesn’t mean lowest price and higher price, The lowest TP is the price seller willing to accept and the maximum is the highest price buyer willing to pay.
Cartoons company has a battery divison that manufactures and sell volt 20
Capacities in batteries 300000
Selling price per battery on outside market 40 $
Variable cost per battery $18
Fixed cost per battery $7
Dont think of fixed cost per unit, think of total fixed cost , the total fixed cost is therefore 300 000*7= 2.1 million
Cartoons company has a scooter division that can use a battery for each of its scooters. The scooter division is currently buying 100 000 batteries per year from outside supplier for 39 $ per battery.
Maximum TP would be 39 $.
Assume that battery division is operating at capacity , therefore currently selling all the 300 k units to the outside customers therefore if you accept the internal order , this means that you would have to forgo and give up the outside sales which is an example of an opportunity cost. If battery wants to sell to scooter division this means that it has to give up some sales.
Minimum transfer price per unit would be the incremental cost of inside sales. Whatever would go up on inside sales + loss contribution margin per unit of outside sales.
In this case the variable cost is 18 + 22 ( 40-18) = 40
Therefore they buying division was the max tp of 39 not gonna pay more than 39 and selling division wants 40. So therefore no transfer would be made.
Situation 2
Battery division now operates at capacity but can avoid 4 $ variable cost for within of company sales. ( lower packaging, lower delivery , lower commissions ect) what price should i chage the scooter division?
The minimum Tp will therefore be
New variable cost would be 18-4= 14 $
Therefore 14 +(40-18)= 36 would be the minimum transfer price
The transfer price would be the lower limit for a transfer price . In this case the transfer price could be from 36-39 $ , anywhere in this range would work
What is the impact of company if divisions cannot reach an agreement on a price between 36-39
Agree they agree at 36 $ ( min tp ) what will be impact on profits of company
Who is chaging 36 ? it is the battery division min tp , remember that at this price profits remain the same for battery division but scotter division gain a 3 $ therefore as selling 100k , profits go up by 300 k, battery division makes same profit indifferent..
Respect autonomy only iterfere if impact of company is material . ( even though managers are engaging in goal incongruent behaviour)
Situation 2
Assume that they agree at 39 $
Therefore the company still makes 300 000k but for now the buying division remains the same and indifferent but the battery division makes a profit of 3 $ per unit
Now what happens if they agree at 37.50 $ , battery profits would be 100 k * (37.50-36) therefore 150 k. Making an increase of 1.50 from what they have targeted as min TP
What about scooter? Therefore 150 k * ( 39-37.50)= 150 K
Situation 3
Now battery division has enough idle capacity to supply the scooter division needs. What price per battery should it charge to scooter division?
Therfore the maximum outside sales would be total capacity – 100000= 200 k
If there is no idle capacity there is no opportunity cost. No outside sales are given up.
Minimum transfer price would be = 18+0=18 $ therefore the transfer price should be at a price agreement of 36 $ to 39 $
Here as we can see if the divisions cannot agree between a price of 18 $ and 39 $, there would be a potential loss for company of 100 k * (39-18) = 2.1 million. Compared to the 300 000 , the 2.1 million is material therefore the CEO should interfere.
Situation 4
Assume that the scooter division wants a heavy duty battery that is not currently produced by battery division. Since it is not currently produced we need to question the accuracy of the costs.
Variable cost of heavy battery 27
Needed each year 50000
Regular battery sales to be given up from battery division 75000
Heavy duties battery consume 50 % more of the resources than regular batteries ( 150 percent of the resources)
Therefore heavy duty= 1.5 reular
50000*1.5= 75000
What transfer price should we charge for the heavy duty batteries
Selling 40
Vc 18
Cm 22
Unit sales lost 75000
Cm lost 22*75000= 1650000
Therefore 1650 000/50000 = 33 $ or 22*1.5=33 $ per unit
Minimum transfer price = VC unit inside + lost cm on outside sales ( opp cost )
Transfer price = 27+33=60
Therefore earining same profit from inside sales and outside sales
Inside= 50 k*( 60-27)=1.65 min outside = 75 k (40-18)= 1.65 M
All actions should be in the long term interest for organization. Goal congruence. Respect autonomy. Divisional heads should not be forced into agreement over a transfer price unless the lost profit for the company as a whole is material.
This price can be backed up by Decentralization which has other some forms of benefits. One person cant do everything. They need to be experts in what they do for the business.
Transfer price examples
Case one
Division s 100000
Division outside sales 100000
Division b needs 30000
Capacity excess ? no
Opportunity cost ? yes
Division s
Variable cost per unit $ 40
Fixed cost per unit 10
Selling price 70
Division B price per unit from outside supplier 68 therefore max tp
Minimum tp therefore would be 40+ (70-40 )=70 therefore no transfer
Case 2
Division s 500000
Division outside sales 500000
Division b needs 80000
Capacity excess ? no
Opportunity cost ? yes
Division s
Variable cost per unit $ 60 but can save 10
Fixed cost per unit 10
Selling price 100
Division B price per unit from outside supplier 96
Therefore case 2 minimum tp would 60-10 +100-60 = 90 therefore transfer from 90-96
Case 3
Division s 250000
Division s outside sales 200000
Division b needs 50000
Capacity excess ? yes
Opportunity cost ? no
Division s
Variable cost per unit $ 30
Fixed cost per unit 8
Selling price 45
Division B price per unit from outside supplier 43
Minimum tp would be 30+0=30
Max tp 43
Therefore tp would be from 30-43
Case 4
Division s 400 000
Division outside sales 300 000
Division b needs 100 000
Capacity excess ? yes
Opportunity cost ? no
Division s
Variable cost per unit $ 50 can save 2 $
Fixed cost per unit 12
Selling price 80
Division B price per unit from outside supplier 75
Therefore minimum tp charge B would be 50-2 +0=48
From 48 to 75 would be the transfer price
Case 5
Division s 400 000
Division s outside sales 300 000
Division b needs 150000
Capacity excess ? no
Opportunity cost ? yes
Division s
Variable cost per unit $ 50 but can save 2$
Fixed cost per unit 12
Selling price 80
Division B price per unit from outside supplier 75
case 5
excess capacity: therefore would be 400 000 -300 000= 100 000 but division b needs 150 000
you losing 50000 to outsiders but gaining 150 inside. So to satisfy division b need division s would have to give up 50000 units of outside sales, therefore the 400 000 capacity would get used as 150 000 insiders and 250 to outsiders instead of 30000
Minimum Tp per unit would be ( 50-2) + 50 000(80-50)/150000=58 $
Earning same profit ?
Insider = 150 k* (58-48)=1.5 million outsider : 250 (80-50)=1.5 million
What factors should we consider when rejecting outside sales to accept internal order?
– we should consider whether the internal order is one time only or is it every year?
– Lost future sales from regular / loyal customers which are not captured by opportunity cost.
Methodology to assess impact on the company as a whole to accept the outsider order.
– An outside order is being considered by the buying division. In order to satisfy the outside order , the buying division needs a part from other division in the company
– However the selling and buying division cant agree as selling price is too high
Approach one
Use incremental approach to assess the impact on each division and company as a whole using the minimum tp and max tp.
Change profit in buying division = max tp to pay that would use and yield 0 profit on outside order – agreed upon price
If buying division paid this price to selling division the profit for the outside sales would be zero.
2) change in profit for selling division would be agreed upon price- minimum tp
3)change in profit for company = change in profit in buying div + change in profit in the selling division = max tp – min tp
Approach 2
Good for the company ( profits would increase) If outside order price is to be received is greater than the total of all internal incremental cost ( incurred by both divisions) plus any opportunity cost.
Long question analysis for transfer pricing
UBC industries is a decentralized organization with six divisions. The company bookstore division produces a variety of books including a x52 small book. The bookstore which is operating at full capacity sells this small book to regular customers for 7.50 $ each.
The small book has a vmoh of $4.25.
The company Irvin division has asked the bookstore to suppy it with a large quantity of the x52 book for 5 $ each . The Irvin division which is operating at 50 % capacity will put the book on the shelf and will be able to sell to a large business owner. The cost of the shelf being build by Irvin would be as follow
Purchased parts from outside vendors 22.50
The small book 5.00
Other variable cost 14.00
Fixed overhead 8.00 ( ignore )
Total cost per brake = 49.50
Although the price of the small book of 5 $ represents a substantial discount from the regular 7.50 each, the manager believes that the price concession is necessary if his/ her division is to get the contract for the airplane brake units. She has heard through the grapevine that the shelf manufacturer plans to reject his bid if its more than 50 $ per brake unti. Thus if the brake division is forced to pay regular 7.50 $ price for the small book it will either not get the contract of it will suffer a substantial loss at a time when it is already operating at 50 % capacity. The manager argues that the price concession is imperative to the well being of both of his / her division and the company as a whole.
UBC uses return on investment to measure divisional performance.
Required :
1) Assume that you are the manager of the Bookstore division . Would you recommend that the division supply the x52 book to the brake division for 5 $ each as requested.? Why or why not ? show all computations
The bookstore division is operating at capacity therefore any sales of the x52 book to Irvin division would mean that the company has to forgo some outside sales.
The minimum TP would be 4.50+(7.50-4.25)=7.50
Therefore the UBC division should not transfer the fitting to the brake division for 5 $ each . The UBC division should get a 7.50 $ on it as management performance is measured by ROI,it would negatively affect manager bonus evaluation if it sells for 5 $
2)Would it be to the economic advantage of company as a whole for UBC division to supply it to Irvin if shelves can be sold for 50 ? show all computations and explain your answer?
The key issue here is that the 8 $ in the fixed overhead cost and administrative costs contained in the Irvin division shelf unit is irrelevant as total fixed cost doesn’t cHage per unit. There is no indication that winning the contract would affect any of the fixed cost . if these costs would be incurred regardless of whether or not the Irvin division get the contract , they should be ignored when determining the effects on the company profits . Another key issue to grasp is that the variable cost of the Irvin division is not relevant either as whether they are used in the shelf or sold to outsiders, the production cost of the would be the same. The only difference between the two alternatives is the revenue on outside sales that is given up are transferred within the company.
Looking at company as a whole
Selling price 50
Less Variable cost would be 7.50
Irvin division : 36.50
Better off by 6 $
3) In principle should it be possible for the two managers to agree to a transfer price in this particular situation?
UBC bookstore would insist on a min tp of 7.50 for the book. Would the Irvin division make any money at this price? Once again the fixed cost are not relevant and it is evident that Irvin would make 6 $ per brake unit.
| Tp 7.50 | Tp 0 | TP 13.50 | |
| Selling price | 50 | 50 | 50 |
| Less
Purchase outside Book Other vc |
22.50 7.50 14 |
22.50 0 14 |
22.50 13.50 14 |
| IRVIN CM | 6 | 13.50 | 0 |
Therfore any tp from 7.50-13.50 will improve the profits of both divisions. The managers should agree on the transfer price..
Would the manager of Irvin pay 13.50( even profits will not increase)
50 % of capacity> avoid layoffs
Other factors qualitative to consider
a) Lost future sales to regular customers
b) The rich guy buying the book , more future opportunies
c) Alternative suppliers for the same book?
Approach one
a) change in profit for the buying division ( Irvin )=
max tp willing to pay – agreed upon pice
therefore max willing to pay would be the profit on outside order without considering the other division price . 50- ( 22.50+14)=13.50-7.50=6
b) Change in profit for selling division: agreed upon price – minimum tp= 7.50-7.50=0
c) Change in profit for comp= Profit for buying division( Irvin) + profit for selling ( bookstore)
=6 +0 =6
Approach two:
Change in profit for Company:
Outside price received – total ( of all incremental cost plus opportunity cost)
=50- ( VC brake 22.50+14+ 4.50+3.50 opp cost )
= 6 $ per unit
4) Discuss the organizational and behavioural problems . If any inherent in this situation , what would you advise the company president to do in this situation?
It is in the best interest of the company and the divisions to come to an agreement concerning the transfer price. As demonstrated in part 3 above any transfer price within 7.50-13.49 would improve the profits of both divisions. What happens to two managers if they do not come to an agreement .
In this case top management knows that there should be a transfer and could step in and force a transfer at some price within an acceptable range. However such action if done on a frequent basis would undermine the autonomy of the managers and company would lose benefits of decentralization.
Advise would be to ask the top managers to meet and discuss the transfer pricing decision. Top management should not dictate a course of action or what is to happen in the meeting but should carefully observe what happens in the meeting. If there is no agreement, It is important to know why. There are at least three possible reasons. First there may have been better information than top managers ( information asymmetry) and refuse to transfer for very good reasons. Second the managers may be uncooperative and unwilling to deal with each other even if it results in lower profits for the company and for themselves. Third the managers may not be able to correctly analyze the situation and may not understand what is actually in their best interest. For example , the manager of the irvin division may believe that the fixed overhead of 8 $ does have to be covered to avoid a loss
If the refusal come to an agreement , is the result of an uncooperative attitudes or an inability to correctly analyze the situation, top management can take some positive steps that are completely consistent with decentralization. If the problem is uncooperative attitudes, there are many training companies that would be happy to put on a short course in team building for company. If the problem is that the managers are unable to correctly analyze the alternatives, they can be sent to executives training courses that emphasize economics and managerial accounting – ie transfer pricing seminar
Respect autonomy , don’t interfere unless dysfunctional behavior has a material impact or negative effect on the company
If the division has an excess capacity ,why would it be willing to accept the minimum transfer price( even though profits stay same)? So as to avoid layoffs.