Transfer pricing - Examples

1
 1. Del Norte Paper Company

• The problem: John Powell, general manager - International

Operations of Del Norte Paper’s Container Division, is faced with the
question of what, if anything, should be done about the reluctance of
Frank Duffy, his Italian subsidiary manager, to use linerboard
manufactured by a Del Norte Paper Company mill in the United States.
The Italian subsidiary, the German subsidiary and 20 outside firms
have recently submitted bids to an African firm for a contract involving
the manufacture of a large quantity of corrugated boxes. DNP-Italia
won the contract with a bid of $400 per ton. The winning bid was
based on the premise that the linerboard would be purchased in the
European “Spot” market

• In order to more clearly understand the entities involved in the case

look at the diagram 1

2
 Del Norte Paper Company

• The question to be resolved in the case analysis is what course of action

would have been best for the overall corporation. The numerical
analysis are shown in the tables 1 and 2, that determine the same result

Diagram 1
African Company

340
550 (460) 400 (325)
to
550

Twenty Outside DNP Deutschland DNP Italia

Firms

3
 Tables 1

• Table 1: Transfer pricing matrix

Transfer price range Available capacity

Maximum price (by DNP Italia) $235
Minimum price (by DNP American mill) $251
Net profit/loss (overall company) ($16)

$235 represents the linerboard cost per ton of

corrugated box sold. The actual cost per ton of
linerboard used was $220. Thus the relevant
ratio is (235/220)=1,07
$251 represents the internal variable costs for
DNP American mill ($190*1,07+$45*1,07)

4
 Tables 2

• Table 2: Make or buy analysis

DNP Italia DNP Deutschland
Spot KEA Spot KEA
European subsidiary: $400 $400 $400 $400
Sales revenue ($325) ($475) ($310) ($460)
Direct costs

DNP American mill $134 $134

Contribution $75 $59 $90 $74

All figures are computed on the basis of one

ton of corrugated box output
The sales revenue amount for DNP
Deutschland is set at $400, as this was the
price in the winning bid
$475= $385+$90; $385 is the KEA price for
corrugated box ($360*1,07); $90 is the
conversion cost ($325-$235)
$310=$235+$75; $235 is the price in the spot
market; $75 is the conversion cost ($460-$385)
$134=$385 less direct costs ($203, or
$190*1,07) and freight cost ($48, or $45*1,07)
5
 Remarks

• As can be seen in these two tables it is unlikely that Frank Duffy’s

decision has cost the firm any lost contribution in this particular instance.
The “Spot” alternative shows $16 more contribution.
• The interesting discovery is that the German subsidiary would have
contributed the most, by buying “Spot” and selling at the $400 price.
This allows the student to raise the question as to why the German
subsidiary manager bid is so high. Three possibilities, at least, come to
mind here.
1. First the manager is German and, thus, follows the rules. That is to say,
the corporation wants KEA-priced and DNP-produced linerboard used
and that’s exactly what he’ll do
2. A second possible reason is that the German subsidiary, like the Italian
one, is viewed and measured as a profit center. Thus, the manager may
simply not wish to show a negative profit contribution on each ton
shipped. As can be seen below, both subsidiaries would show a loss if
they used KEA-priced linerboard

6
 Remarks

DNP Italia DNP Deutschland

Sales revenue (per ton) $400 $400
Direct costs, at KEA invoiced prices ($475) ($460)
Contribution ($75) ($60)

3. Finally, is the hypothesis that the German manager full well knows what
he’s doing. He may simply not want this business. He is quite possibly
either at or near capacity, or believes that he will be at such a position
before the order could be filled.

7
 Remarks

• The possibility exists that Powell’s real concern is that he wanted Duffy
to use KEA-priced and DNP-produced linerboard for tax evasion (in
Italy) purposes. If the linerboard is invoiced at $385 per ton, as
opposed to $235 per ton, $150 per ton of taxable income is, in effect,
transferred out of Italy. This is done via the route of having a higher
cost-of-goods-sold figure. Thus, while the overall contribution to the
corporation may be marginally lower using KEA linerboard, the firm’s
after-tax contribution might be higher. This would be true if Italy’s
marginal tax rate exceeded that in the United States.

8
 2. Burger Rama
• The problem: Jane Garton has to evaluate the convenience for the
overall company of internal transfer rather than external purchasing
• As in the Del Norte Paper Company case, it’s possible to resolve the
problem defining the Transfer pricing matrix or using the “make or buy
analysis”
• As shown in the following tables, the internal transfer generates a net
convenience of $1320

• Table 1: Transfer pricing matrix

Transfer price range Available capacity
Maximum price (by Cape drive-in) $3,3
Minimum price (by ice-cream manager) $2,10 + $0,32
Net profit/loss (overall company) $0,88
Total profit $0,88*1500=$1320
$3,3 represents the price from outside supplier
$2,10 represents the internal variable cost
$0,32=$480/1500 represents the differential
fixed cost for unit generated by the internal
transfer 9
 Burger Rama

• Table 2: “Make or buy analysis”

Selling unit (ice-cream unit) Buying unit 1. Internal transfer

Costs:
Revenue: $4*1500=$6000 ($4*1500)=($6000)
Variable costs: ($2,10*1500)=($3150)
Fixed costs: ($5000)
Overall company
($8150)

Selling unit (ice-cream unit) Buying unit 2. External purchasing

Fixed costs: ($4520) ($3,3*1500)=($4950)
Overall company
($9470)

10
 3. Mason Corporation

• The problem: the president of the company has to evaluate the

convenience for the overall company of internal transfer rather than
external purchasing
• As in the Del Norte Paper Company case, it’s possible to resolve the
problem defining the Transfer pricing matrix or using the “make or buy
analysis”
• We assume that the fixed costs ($60000) are not differential costs
generated by the internal transfer, because it’s not possible to save
them in the case of external purchasing
• In addition, try to resolve the problem assuming that fixed costs are
differential elements

11
 Table 1: transfer pricing matrix

Transfer price range Question 1 Question 2 Question 3

Maximum price (by Pacific) $300 $270 $300
$285 + ($330-
Minimum price (by Southern) $285 $285 $285-$12)=$318
Net profit/loss (overall company) $15 ($15) ($18)
Total profit/loss $15*2000=$30000 ($15*2000=$30000) (18*2000=$36000)
$300 represents the price from outside supplier
$285 represents the internal variable cost
$330-$285-$12= $33 represents the The external
contribution margin lost if Southern doesn't sell The internal transfer The external purchasing purchasing is
to other customers is convenient is convenient convenient

12
 Table 2: make or buy analysis

1° question
Selling unit (Southern unit) Buying unit (Pacific) 1. Internal transfer
Costs:
Revenue: $330*2000=$660000 ($330*2000)=($660000)
Variable costs: ($285*2000)=($570000)

Overall company
($570000)

Selling unit (Southern unit) Buying unit (Pacific) 2. External purchasing

($300*2000)=($600000)
Overall company
($600000)
It's convenient the internal transfer
13
 Table 2: make or buy analysis
2° question
Selling unit (Southern unit) Buying unit (Pacific) 1. Internal transfer
Costs:
Revenue: $330*2000=$660000 ($330*2000)=($660000)
Variable costs: ($285*2000)=($570000)

Overall company
($570000)

Selling unit (Southern unit) Buying unit (Pacific) 2. External purchasing

($270*2000)=($540000)
Overall company
($540000)
It's convenient the external purchasing

14
 Table 2: make or buy analysis

3° question
Selling unit (Southern unit) Buying unit (Pacific) 1. Internal transfer
Costs:
Revenue: $330*2000=$660000 ($330*2000)=($660000)
Variable costs: ($285*2000)=($570000)

Overall company
($570000)

Selling unit (Southern unit) Buying unit (Pacific) 2. External purchasing

Revenue: $330*2000=$660000 ($300*2000)=($600000)
Variable costs: ($285+$12)*2000=($594000)
Overall company
($534000)
It's convenient the external purchasing

15