MANAGERIAL ACCOUNTING TRANSFER PRICING Overview

SOMNATH DAS

The essential feature of decentralization in large firms is the creation of responsibility centers (e.g. cost, profit, or investment centers). The performance of these responsibility centers is evaluated on the basis of various accounting numbers, such as standard and actual cost, divisional profit or return on investment. A central role of the management accounting system therefore is to evaluate (i.e. attach a dollar figure to) the transactions between the different responsibility centers. Under the subject cost allocation we studied alternative methods to charge user departments for the services rendered by service departments (fre uently cost centers). Transfer prices are used to evaluate the goods and services e!changed between profit centers (divisions) of a decentralized firm. "ence, the transfer price is the price that one division of a company charges another division of the same company for a product transferred between the two divisions. # # # There are no cash flows between the divisions. The transfer price is used only for accounting purposes. The transfer price becomes an e!pense for the receiving manager and a revenue for the supplying manager. #f intra$company transfers are accounted for at prices in e!cess of cost, appropriate elimination entries have to be made for e!ternal reporting purposes. %!amples of items to be eliminated for consolidated financial statements include& # # # #ntra$company receivables and payables. #ntra$company sales and costs of goods sold #ntra$company profits in inventories.

Purposes of Transfer Pricin There are two major reasons to operate a transfer pricing system& # Appropriate transfer prices help to coordinate the production, sales and pricing decisions of the different divisions. Transfer prices ma'e managers aware of the value that the goods and services have to other segments of the firm. # The use of transfer prices allows the company to generate separate profit figures for each divisions and thereby to evaluate the performance of each division separately. 1

A!"erna"ive Me"#o$s of Transfer Pricin Transfer pricing policies specify the rules that are being used to calculate the T(. #n addition, a T( policy has to be specific about the sourcing uestion, i.e., are divisions free to buy)sell e!ternally or is it the case that internal transfers are mandated. *. +ar'et$based Transfer (ricing #n the presence of competitive and stable e!ternal mar'ets, many firms ta'e the e!ternal mar'et price as a benchmar' for their internal transfer price. ,enerally, the e!ternal mar'et price provides a ceiling not to be e!ceeded by the internal transfer price. -uestion& "ow would you argue that mar'et price is the .correct. T( if the e!ternal mar'et is perfectly competitive/ #ssues with mar'et$based T(& #mperfect 0ompetition 1istress (rices $(rotecting .infant. segments 2. 3egotiated Transfer (ricing "ere, the firm does not specify rules for the determination of transfer prices. 1ivisional managers are encouraged to negotiate a mutually agreeable transfer price. 3egotiated transfer pricing is typically combined with free sourcing. #n some companies, though, ".-. reserves the right to interfere in the negotiation process and impose an .arbitrated. solution. -uestion& 4hat do you perceive to be the major advantages)disadvantages of negotiated transfer pricing/ 5. 0ost$based Transfer (ricing #n the absence of an established mar'et price many companies base the T( on the production cost of the supplying division. *. 2. Fu!! %a&sorp"ion' cos"6 either standard or actual. (opular because of its simplicity and clarity. Cos"(p!us 7or transfers at full cost the buying division ta'es all the gains from trade while the supplying division receives none. To overcome this problem the supplying division is fre uently allowed to add a mar'$up in order to ma'e a .reasonable. profit. The transfer price may then be viewed as an appro!imate mar'et price. E)AMPLE* The following e!ample, however, illustrates potential problems with this T( 2

method. The A80 company consists of two divisions& A and 8. 1ivision A9s output is an intermediate product that is completed and mar'eted by the 8 division. The following cost and revenue information applies& 1ivision A& 1ivision 8& 7i!ed 0ost 7i!ed 0ost & :;<<< & :5,<<< =ariable 0ost & :2 per unit =ariable 0ost & :*< per unit %ach unit of the final product re uires one unit of the intermediate product plus certain other inputs (provided by 1ivision 8) leading to a variable cost of *<. 7or the final product y 1ivision 8 estimates that the mar'et demand curve is given by& ( > *? 8 .<<* @ y. Auppose that the supplying division is entitled to a mar'$up of 2BC above full cost. =erify that transferring 2<<< units of ! (the intermediate product) at a transfer price of :B is .desirable. for both divisions. #s it optimal from A809s perspective if 2<<< units are transferred/

+aria&!e Cos" p!us Lu,p Su, C#ar e* #n order to motivate the buying division to ma'e appropriate purchasing decisions, the transfer price could be set to (standard) variable cost plus a lump$sum periodical charge covering the supplying division9s related fi!ed costs. -uestion& Apply this method to the setting in the above %!ample. +aria&!e Cos" p!us Oppor"uni"- Cos"& Dur te!t boo' advocates what is 'nown as the "orngren$7oster rule. According to this rule the minimum T( is the sum of two elements& i) ii) #ncremental costs incurred to the point of transfer& cash outflows that are directly associated with the production of the transferred goods. Dpportunity costs for the firm& the contribution margin foregone by the firm as a whole if the goods are transferred internally. -uestion& #n the e!ample above, suppose that the supplying division (A) can sell the intermediate product e!ternally at a price of :E per unit after incurring additional variable cost of :; per unit. 4hat transfer price would you advocate in this situation/ ("#3T& 1epends whether there is a 0apacity constraint or not.) -uestion& 7or the setting considered in the above e!ample, suppose there are now two internal buying divisions, i.e., there is also a division 0 for which the intermediate product ! is a component of its mar'etable product. Auppose also that the supplying division A is subject to capacity constraints. #n what way can the approach of the "orngren$7oster$1atar rule be used to arrive at an optimal transfer price/

Transfer Pricin Prac"ices +ethod Used 0ost based +ar'et based 3egotiated TDTAH 3ote& 0ompanies using other methods are e!cluded from the above analysis. They comprise 2 percent or less of the total.
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United Atatesa ;BC 55 22 *<<C

0anadab ;GC 5B *E *<<C

Fapanc ;GC 5; *? *<<C

A. 8or'ows'i, %nvironmental and Drganizational 7actors Affecting Transfer (ricing& A Aurvey, I. Tang, 0anadian Transfer (ricing (ractices, CA Magazine, +arch *?E<.

Journal of Management Accounting Research, 7all *??<.

b c

I. Tang, 0. 4alter, and I. Iaymond, Transfer (ricing $ Fapanese =s. American Atyle, 7or a more recent and comprehensive summary survey of current practices in transfer pricing

Management Accounting, Fanuary *?G?. 3DT%&

see "orngren$1atar$7oster. Ta. Consi$era"ions in "#e C#oice of Transfer Prices #f the divisions involved belong to different ta! jurisdictions, the choice of transfer price will be partly affected by ta! considerations. 0onsider the following e!ample. %!ample $ Ta! implication of transfers across countries. A and 8 are divisions of the A80 company. The A division is located in the U.A. where the marginal ta! rate is 5BC. The 8 division is located in ,olanjia where the marginal ta! rate is *BC. The A division produces an intermediate product at a cost of :*<< per unit and then transfers this product to the 8 division where it is finished at an additional cost of :*<< and sold for :B<<. Assume *,<<< units are transferred annually and that the minimum transfer price is the variable cost. -uestion& 4hat transfer price should be charged in order to minimize ta!es/