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Transfer pricing methods Is the price one subunit (department/division) charges for a product or service to another subunit of the

he same organization Transfer price creates revenues for the selling subunit and purchase cost of the buying subunit, affecting each subunits income


Car Manufacturer

Sells Car engine to Assembly Division Engine Manufacturin g Division Pays EMD for the car engine Car Assembly Division

The product or service transferred between subunits of an organization is called an intermediate product ( ex. The car engine)

3 methods for determining transfer prices: Market-Based transfer pricing Cost-Based transfer pricing Negotiated Transfer pricing

Market-based transfer prices

Top management may choose to use the price of a similar product or service publicly listed in, say, a trade association. Website. Also, top management may select, for the internal price, the external price that a subunit charges to outside customers Transferring products and services at market prices generally leads to optimal decisions when three conditions are satisfied: Market for the intermediate product is perfectly competitive Interdependencies of subunits are minimal There are no additional costs or benefits to the company as a whole from the buying and selling in the external market instead of transacting internally

Perfectly-Competitive-Market exists where homogenous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions If transfer prices between subunits < market price, then the selling subunit would sell all of its products to external buyers who would purchase it @ market price If transfer price > market price, buying subunit would be motivated to purchase required materials from external suppliers Only with a transfer price @ market price would motivate both subunits to buy and sell in internally because neither subunits would profit

Use of M-B transfer prices in a perfectly competitive market by a company can: Promote goal congruence Motivate management effort Evaluate subunit performance Preserve subunit autonomy

Distress Prices when supply > demand, market prices decrease. The drop in prices is expected to be temporary, these low prices are sometimes called distress prices

IN the short run, selling subunit should supply the product/service at distress price as long as it exceeds incremental costs of supplying the product/service. Selling subunit would show a loss because DP < full cost

Cost-based transfer prices

Are helpful when market prices are unavailable, inappropriate or too costly to obtain, ex. when the product is specialized, or when the internal product is different from those offered by external producers in terms of quality and service o Full-Cost Bases to approximate market prices, Cost Based transfer prices are sometimes set at full cost plus margin. These transfer prices, however, can lead to suboptimal decisions Requires an allocation of each subunits fixed cost to products Managers generally prefer to use FCB transfer prices because these transfer prices represent relevant costs for long-run decisions, they facilitate external pricing based on variable and fixed costs, and they are least costly to administer

Variable-Coast Bases - setting the transfer price equal to the variable cost of the selling subunit. This achieves goal congruence since buying subunit would purchase from the selling subunit for the transfer price is less than the market price charged by external sellers. But selling subunit would record an operating loss unless buying subunit would make a lump sum payment to cover the fixed cost and generate some income for the selling subunit

Dual Pricing - using two separate transfer-pricing methods to price each transfer from one subunit to another Is not widely used in practice due to problems in computing the taxable income located in different tax jurisdictions It also insulates managers from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying subunits

Negotiated transfer prices

Result from the bargaining process between selling and buying subunits. This approach is particularly useful in cases with market imperfections, such as the ability of an in-house division to avoid selling and distribution costs that external market participants would have to incur Using a negotiated transfer price allows the subunits to share any cost savings resulting from avoided costs Bargaining range exists from the minimum to the maximum transfer price: o Minimum/Floor transfer price the transfer price that would leave the selling division no worse off if the goods were sold to an internal subunit than if the goods were sold to an external party Maximum/Ceiling Price the transfer price that would leave the buying subunit no worse off if an input were purchased from an internal division than if the same goods were purchased externally.

Example: $50 Market Price - $5 selling commission that can be avoided on internal sales = $45 minimum transfer price

Minimum transfer price =

Incremental cost per unit incurred up to the point of transfer +

Opportunity cost per unit to the selling subunit

Incremental cost additional cost of producing and transferring the product/service

Opportunity cast the maximum contribution margin forgone by the selling subunit If the product/service is transferred internally

Criteria Achieves goal congruence Motivates management effort

Market-Based Yes, when markets are Competitive Yes

Useful for evaluating subunit performance

Yes, when markets are Competitive

Cost-Based Often, but not always Yes, When based on budgeted costs; less incentive to control costs if transfers are based on actual costs Difficult unless transfer price exceeds full cost and even then is somewhat arbitrary No, because it is rule-based Useful for determining full cost of products and services; easy to implement

Negotiated Yes Yes

Preserves subunit autonomy Other factors

Yes, when markets are Competitive Market may not exist, or markets may be imperfect or in distress

Yes, but transfer prices are affected by bargaining strengths of the buying and selling divisions Yes, because it is between negotiations between subunits Bargaining and negotiations take time and may need to be reviewed repeatedly as conditions change

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