Transfer pricing

1
Transfer pricing

• 6 maggio 2008

2
Horizontal dimension at the business unit level

• Business units as independent units which have
  the responsibility on one product/market
• To evaluate the economic behavior of BU the top
  management has to solve the following problems
• the definition of partial Profit/Loss statements
  for Business Unit
• the evaluation of possible internal trade
  (goods/services) between business units (transfer
  pricing determination).

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Transfers within the company

• A transfer is referred to the movement of goods
  from a responsibility center to another, within
  the same company
• Different types of responsibility center,
  belonging to different organizational levels, are
  involved in the transfers

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Transfers within the company the profit centers

• If the manager of a responsibility center is
  allowed to sell the produced part (intermediate
  product) also to outside customers (he is not
  obliged to sell the part exclusively to another
  company center), its responsibility center is a
  profit center (the manager has the responsibility
  both on costs and revenues)
• The manager of a profit center must choose
  between the alternative of selling outside or
  transferring the part within the company (which
  customer, external or internal, is giving the
  higher price?)
• The manager which uses the intermediate product
  must choose between the alternative of purchasing
  it from outside supplier or from an internal unit
  (which supplier, internal or external, is giving
  the lower cost?)
• If the transfer is not obliged (from a profit
  center) its value is called transfer pricing
• The problem is how transfer prices should be
  defined?

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Transfers within the company top management and
division managers

• Top management wants to have information about
  the transfers between profit centers because he
  wants to have the maximum overall company profit
  
• Due to the fact that transfer pricing provides
  a rule for sharing transfer extra-profit between
  division managers, these managers are interested
  in its definition
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result is obtainable through the
  application of the make-or-buy data analysis

6
Optional transfers between profit centers which
transfer price?

• We use the following example Yard Equipment
  Company and its responsibility centers Braxton
  and Clipper units
• 1 case Braxton produces engines. It is a profit
  center it is not obliged to transfer engines to
  Clipper division and can sell engines outside in
  the market Clipper division is a profit center
  as well.
• The question is which is the value used for the
  transfer?

External customers
Engines
Finished product (grass-cutting machine)
Braxton
Ouside market of finished product
Clipper
External customers
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Optional transfers between profit centers which
transfer price?

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Transfer price is an internal price for optional
  transfers of an intermediate product from a
  profit center to another profit center
• Both the managers of the selling unit and the
  buying unit must agree on the transfer
• Anyway, the transfer is convenient only if the
  overall company profits are increasing
• Three are the studied situations
• 1. Braxton has available capacity in excess to
  realize the internal transfer to Clipper
• 2. Braxton has not capacity in excess
• 3. Differential fixed costs are generated by the
  internal transfer

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1. Optional transfers from profit centers
available capacity

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Braxton is selling 100 engines to outside
  customers at price per unit300
• Braxton has capacity of producing 150 engines
  monthly
• Clipper manager wants to buy 50 engines and not
  more, so that Braxton capacity is sufficient to
  realize the transfer to Clipper without
  abandoning the external sales
• The Braxton and Clipper data are the following

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1. Optional transfers from profit centers
available capacity

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Braxton is saving variable sale costs for 15 if
  it transfers engines to Clipper
• Clipper manager has two alternatives to buy
  engines from the outside supplier at 275 or to
  buy engines from Braxton. He wants to obtain the
  lower cost engine, so that his superior limit of
  price for the internal transfer is 275 (he
  obviously accepts any lower price)
• Braxton manager wants an internal price so that
  he can maintain his already achieved contribution
  margin. If Braxton has capacity in excess the
  alternatives are to sell 50 engines to Clipper
  or not to produce these engines due to the fact
  that there are not any other external customers.
  Consequently, the internal transfer price must
  cover at least the internal standard variable
  costs (175). Obviously, Braxton manager accepts
  any other higher price. Anyway, 175 is the
  inferior limit of price for the internal transfer
  
• Yard Equipment Company wants to obtain the
  engines at the lower costs. The overall company
  has two alternatives to produce 50 extra engines
  in the Braxton division or to buy these motors
  for Clipper division from an outside supplier at
  275. Obviously the overall company prefers the
  internal transfer because it manages to save 100
  per engine

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1. Optional transfers from profit centers
available capacity

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• The convenience (extra-profit or cost saving) for
  Yard Equipment Company is obtainable from the
  difference between the maximum price (determined
  by Clipper) and the minimum price (determined by
  Braxton)
• GENERAL RULE a transfer price range is so
  existing, acceptable for both the managers. If
  the superior limit (max price for buying
  division) is higher than the inferior limit (min
  price for selling division), Yard Equipment
  Company has got always extra-profit from the
  transfer, if the selling division has capacity in
  excess. Both the managers should agree to realize
  the transfer

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2. Optional transfers from profit centers not
available capacity

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Braxton is saturating his capacity with the
  external sales (150 engines, all sold to external
  customers). Its inferior limit is different
  because its alternatives are different to sell
  all the engines to outside customers or to
  transfer a part of them (50) to Clipper. In this
  case, achieving the break-even means maintaining
  the same contribution margin obtainable by the
  external sales
• Inferior limit175110285
• Alternatively we can derive the Inferior limit if
  the capacity is saturated (by selling division)
  as Normal Selling price (300) - Normal Variable
  costs saved with the internal transfer (15)
  285

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2. Optional transfers from profit centers not
available capacity

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Clipper division has again a superior limit of
  price of 275 (engine price from external
  supplier). It is not influenced by the level of
  Braxton capacity
• Yard Equipment Company saves costs of 100
  (internal production, 175, respect to external
  purchasing price, 275), but it loses a
  contribution margin of 110 for each engine not
  sold to outside customers. Consequently, Yard has
  a net loss of 10 for each transferred engine. In
  fact, the different between the superior limit of
  price (by buying division), 275, and the
  inferior limit of price (by selling division),
  285, is negative,
• -10

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Optional transfers from profit centers the
transfer pricing matrix

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• To compare the two situations the tool is the
  Transfer pricing Matrix. It gives to the managers
  the relevant information to decide about the
  internal transfer

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3. Optional transfers from profit centers
differential fixed costs

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Suppose that Braxton has to occur additional
  fixed costs to produce engines for Clipper
  because Clipper wants 20 engines with specific
  features (ex. with a particular name printed
  above). Braxton has to buy a specific printing
  machine for 1000, not usable for normal engines.
  The internal transfer generates differential
  fixed costs. The transfer pricing matrix is so
  modified (fixed costs as a total)

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3. Optional transfers from profit centers how is
modified the transfer pricing matrix with
differential fixed costs

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• fixed costs as amount per unit

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Optional transfers from profit centers the
choose of the transfer pricing and the sharing of
the profits

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Use of the superior limit of price (transfer
  price275)
• considering the situation of capacity in
  excess, all the transfer extra-profits 100 are
  associated to Braxton division (Transfer pricing
  275 - Internal variable costs 175100)
  Clipper manager is indifferent respect the
  external or internal buying
• Use of the inferior limit of price (transfer
  price175)
• all the transfer profits are associated to
  Clipper division
• Use of the average point in the interval
  (transfer price225)
• the transfer profits are shared in equal
  parts between the two division (225-17550 for
  Braxton 275-22550 for Clipper)

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Optional transfers from profit centers not
available capacity and incremental fixed cost

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• GENERAL FORMULA for Inferior limit (by selling
  division) is as follows
• Ivc Variable internal costs
• Cmu Contribution margin per unit of product,
  lost due to the fact the selling division has not
  sold to outside customers
• Dfc Differential fixed cost for unit of product,
  if it exists, generated by the internal transfer
  (look at the 3 situation)
• Inferior limit of priceIvcCmuDfc

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Optional transfers from profit centers the
choose of the transfer pricing and the sharing of
the profits

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Transfer pricing is only a rule for sharing
  transfer extra-profit between division managers
  any transfer price is at the end chosen, the
  overall company extra-profit derived from the
  transfer does not change
• The transfer overall profit is equal to the
  difference between the superior limit of price
  (by buying division) and inferior limit of price
  (by selling division). Each price is fixed, in
  fact, the sum of division profits is always equal
  to the company overall profit derived by the
  transfer

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Optional transfers from profit centers who
should decide the transfer pricing?

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• If managers of divisions are not evaluated and
  rewarded on the base of the transfer
  extra-profit, there is no real conflict in the
  transfer pricing fixing. The controller can
  decide the level of transfer pricing without
  particular conflicts
• If managers are evaluated and rewarded on the
  base of the profit derived by internal transfer,
  there is a potential great conflict related to
  the transfer price fixing. The internal transfer
  can be compromised even if the overall company
  profit is increasing because managers of
  divisions do not agree about the profit sharing.
  Different options can be followed by controller
• - fixing a transfer price, declaring the
  sharing of profit. The established price is
  sometimes useful to save taxes at the overall
  company level moving profits from higher tax rate
  countries to lower tax rate countries
• - requiring the transfer, but not fixing a
  transfer price, asking that the managers
  negotiate it (long time could be necessary in
  this case, but the managers accept the
  transfer)
• anyway, you realize that the transfer pricing
  problem is very hard in the modern management
  control systems

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Obliged transfers from cost centers

• 2 case Braxton unit is a cost center (it is
  obliged to transfer engines to Clipper division
  that is a profit center. Braxton cannot sell
  engines outside)
• The question is which is the value used for the
  transfer?

Other division
Engine
Finished product (grass-cutting machine)
Braxton
Ouside market of finished product
Clipper
Other division
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Obliged transfers from cost centers alternative
value options
1. Transfer at cost which cost?
(actual/standard, full/variable) 2. Transfer at
market price
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Obliged transfers from cost centers which cost?

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Braxton shows a negative variance both in the
  variable costs (10 per engine) and in the fixed
  costs (10 per engine) for a total negative
  variance of 20 per engine (20100 engines2000
  total)
• If the actual cost is used as transfer cost,
  overall Yard Equipment Company could have
  problems in terms of
• 1. Braxton manager has not incentive to control
  costs because he realizes that any actual cost
  will be transfer to the Clipper Division (20 are
  hidden in the grass-cutting machine costs)
• 2. It could be difficult to evaluate each
  manager performance. Obviously, Clipper manager
  is not available to accept the variance in his
  evaluation of performance. If other components
  are transferred on the base of actual cost, the
  total cost of finished product includes all the
  variances. Consequently it is very difficult to
  find the responsibilities and to evaluate the
  performances
• 3. Clipper manager has problems in forecasting
  his costs. In fact, he knows the engine cost only
  at the actual transfer moment. It could be late
  for changing the final price of the product to
  take into consideration the major engine cost
  

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Obliged transfers from cost centers which cost?

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• If the standard cost is used as transfer cost
  (18000transferred costs, 2000variance at the
  Braxton cost center)
• 1. Braxton manager has incentive to control costs
  because his evaluation is based on the obtained
  variances
• 2. Clipper manager is able to do better
  forecasting about his production costs
• Standard cost variable or full?
• 1. If full cost is used as transfer price, it is
  possible to determine a more appropriate selling
  price for the finished product (cost mark-up).
  In addition, the variance about fixed costs is
  correctly associated to the Braxton
  manager(right evaluation).
• 2. If variable cost is used, the fixed costs are
  not included in the transfer costing of the
  engine. The fixed costs will be charged to the
  cost of sold goods as an overall sum. In this way
  the referring to the cost centers responsible for
  the variances is lost.

24
Obliged transfers from cost centers which cost?

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• If outside suppliers are existing and Clipper
  division can buy from them, a market price is
  available as transfer costing
• Market price represents the opportunity cost to
  obtain the engines, but it does not represent a
  real cost. In fact, if the market price is used
  as transfer price, the cost of grass-cutting
  machine could be over-evaluated in the case the
  engine cost of Braxton is lower than the market
  price (250)

25
Obliged transfers from cost centers which cost?

• Top management wants to have information about
  the transfers between profit centers because
  wants to have the maximum overall company profit
• A specific tool is available to have the relevant
  information about internal transfer. The tool is
  called Transfer Pricing Matrix
• The same result, as well realize through a set
  of examples, is obtainable through the
  application of the make-or-buy data analysis

• Yard Equipment Company saves costs due to the
  fact Braxton division produces engines (250
  -200)100 engines5000
• But, since Braxton division cannot sell engines
  to outside customers, the positive variance is
  only an unreal profit (a dummy profit) for
  Braxton division and a major cost for Clipper
  division
• In the reality, a market price is sometimes used,
  creating an unreal profit in the statement of the
  supplier-division. Possible reasons are the
  following
• 1. Taxes implications for the multinational
  companies. If, for example, the engine cost
  production is lower in Mexico than in California
  (lower costs of labor), and the Braxton
  production is consequently made in Mexico, the
  resulting cost of grass-cutting machine in
  California should be lower and the taxes on
  income higher. If the California tax-rate is
  major than Mexico tax-rate, it is convenient to
  use the 250 market price to bring the 5000
  profit to Braxton division in Mexico. This profit
  moving allows Yard Equipment Company to really
  save costs for taxes.
• 2. Creation of a responsibility on profit. As a
  first step towards the transformation of a cost
  center into a profit center