Transfer Pricing, Evaluating and Managing Performance

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• Transfer Pricing,Evaluating and Managing
  Performance

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Transfer Pricing

• The amount charged when one division of an
  organization sells goods or services to another
  division.

Battery Division
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Impact of Transfer Pricing on Organizations

• If the divisions are evaluated on profitability,
  the transfer price can have an impact on the
  performance of each division.

Battery Division
Auto Division
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Setting Transfer Prices

• The value placed on transfer goods is used to
  make it possible to transfer goods between
  divisions while allowing them to retain their
  autonomy.

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Goal and Behavioral Congruence
In a decentralized organization, the managers of
profit centers and investment centers often have
considerable autonomy in deciding whether to
accept or reject orders and whether to buy from
inside or outside the organization.
The goal in setting the transfer price is to
provideincentives for each division manager to
act in thecompanys best interests.
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General Transfer-Pricing Rule
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Setting Transfer Prices

• Lets consider two different examples of setting
  transfer prices.
• The company has no excess capacity.
• The company has excess capacity.

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Scenario 1 No Excess Capacity

• The Battery Division of Wills Company makes a
  standard 12-volt battery. The division is
  currently producing at capacity of 300,000
  batteries, and sells each battery to outside
  companies for 60. The company has no excess
  capacity. The Vehicle Division offers to purchase
  100,000 batteries for 45 each.

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Scenario 1 No Excess Capacity
Battery Division
Transfer price Outlay cost Opportunity cost
60

40

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Vehicle Division
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Scenario 1 No Excess Capacity
The offer of 45 per battery by the Vehicle
Division will not be accepted by the Battery
Division.
Battery Division
Transfer price Outlay cost Opportunity cost
60

40

20
Vehicle Division
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Scenario II Excess Capacity

• The Battery Division of Wills Company makes a
  standard 12-volt battery. The division is
  currently producing 200,000 batteries. Full
  capacity for the Division is 300,000 batteries.
  The Division currently sells all batteries to
  outside companies for 60 each. The Vehicle
  Division offers to purchase 100,000 batteries for
  45 each.

The offer of 45 per battery by the Vehicle
Division will be accepted by the Battery
Division. Each batterysold to the Vehicle
Division will produce 5 in contribution to the
Battery Division.
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Difficulty in Implementing the General Rule

• The general rule is often difficult or impossible
  to implement due to the difficulty of measuring
  opportunity costs.
• Under imperfect competition, a single producer
  can affect the market price by varying the amount
  of product available in the market.
• Transfer pricing can be quite complex when
  selling and buying divisions cannot sell and buy
  all they want in perfectly competitive markets.

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Transfers Based on the External Market Price

• General Rule When Producing Division Has No
  Excess Capacity and Perfect Competition Prevails
• Transfer price Outlay cost Opportunity
  costTransfer price Market price

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Transfers Based on the External Market Price

• The Producing Division Has Excess Capacity or the
  External Market is Imperfectly Competitive
• If the transfer price is set at market price, the
  producing division should have the option to
  either produce goods for internal transfer or
  sell in the external market.
• The buying division should be required to
  purchase goods from inside its organization if
  the producing divisions goods meet the product
  specifications.

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Transfers Based on the External Market Price
Distress Market PricesOccasionally an industry
experiences a period of significant excess
capacity and extremely low prices.
Basing transfer prices on market prices can lead
to decisions that are not in the best interests
of the overall company
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Negotiated Transfer Prices
Division managers actually negotiate the price at
which transfers will be made.
Although negotiating skill is a valuable
managerial talent, it should not be the sole or
dominant factor in evaluating a division
Negotiations can lead to divisiveness and
competition between participating division
managers.
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Cost-Based Transfer Prices

• When a company does not use market prices or
  negotiated prices to determine transfer price, it
  usually turns to cost-based transfer-pricing.

• The cost-based transfer price may be based upon
• Unit-level cost.
• Absorption cost.

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Using Standard Unit-Level Cost
When using this approach, the producing division
is not allowed to show any contribution margin on
the transferred products or services. The
producing division has no positive incentive to
produce and transfer products or services
efficiently.
Some companies avoid these problems by setting
the transfer price at standard unit-level cost
plus a markup.
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Using Absorption Cost
Absorption cost is equal to the products
unit-level cost plus an assigned portion of the
higher-level costs (batch-level,
product-line-level, customer-level, and
facility-level costs.
The Battery Division has unit-level costs of 40
and assigned higher-level costs of 3,600,000.
The Division expects to produce 200,000 batteries
during the period.
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Dysfunctional Decision-Making

• The Battery Division has excess capacity of
  100,000 units and uses absorption cost to set the
  transfer price of 58 per battery.
• The Vehicle Division offers to purchase 100,000
  batteries at a price of 55 per battery.
• Will the offer be accepted?

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Dysfunctional Decision-Making
It appears the offer will be rejected.
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Standard versus Actual Costs
Transfer prices should not be based on actual
costs because such a practice would allow an
inefficient producing division to pass its excess
production costs on to the buying division via
the transfer price.
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Remedying Motivational Problems of
Transfer-Pricing Policies

• If profits of the selling division are too low,
  the manager has no motivation to make internal
  transfer.
• Consider treating the selling division as a cost
  center.
• Consider a profit center for external sales and a
  cost center for internal transfers.

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Undermining Divisional Autonomy

• Top management may become swamped with pricing
  disputes causing division managers to lose
  autonomy.

I just wont pay 58 for that battery!
You really dont have any choice!
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Undermining Divisional Autonomy
Top management may become swamped with pricing
disputes causing division managers to lose
autonomy.
Now, here is what the two of you are going to do.
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Dual Transfer Prices
A dual transfer-pricing system charges 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.
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Multinational Transfer Pricing

• Since tax rates are different in different
  countries, companies have incentives to set
  transfer prices that will increase revenues in
  low-tax countries and increase costs in high-tax
  countries.

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Multinational Transfer Pricing
Country A imports materials from the companys
Country B facility. The tax rate in Country A is
70 percent and in Country B is 40 percent
Country A(40 tax rate)
Country B(70 tax rate)
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Multinational Transfer Pricing

• Country A can use a transfer price of 3,000,000
  or 10,000,000. Lets see the impact of this
  pricing.

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Segment Reporting

• Companies engaged in different lines of business
  are required to report certain information about
  segments.
• Revenue.
• Operating profits or losses.
• Identifiable segment assets.
• Depreciation and amortization.
• Capital expenditures.
• Certain specialized items.

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Segment Reporting

• If a company has significant foreign operations,
  it must disclose . . .
• Revenues.
• Operating profits or losses.
• Identifiable assets by geographic region.

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Transfer Pricing in the Service Industry
Service industry firms and nonprofit
organizations use transfer pricing when services
are transferred between responsibility centers.
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End of Chapter 19