Transfer Pricing

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Transfer Pricing

• Sourcing Decisions
• Manager Autonomy
• Performance Evaluation

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Profit centers and transfer pricing
TRANSFER PRICE
A PRICE CHARGED BY ONE SEGMENT OF ANORGANIZATION
FOR A PRODUCT OR SERVICETHAT IT SUPPLIES TO
ANOTHER SEGMENT OFTHE ORGANIZATION.
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Objectives of transfer pricing schemes

• Encourage managers to make decisions that are in
  the organizations best interest.
• Provide information for evaluation of business
  units and managers.
• Minimize tax obligations (we will ignore)
• Constraint The scheme chosen should require
  little intervention by top management.

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The unifying principle is opportunity cost
The general transfer pricing rule
T VC OC
VC OUTLAY COSTS INCURRED TO THE POINT
OF TRANSFER USUALLY APPROXIMATED BY
STANDARD VARIABLE COST
OC OPPORTUNITY COST TO THE FIRM
(I.E., CONTRIBUTION FOREGONE CM)
Note that CM SP - VC, so VC OC SP - the
market pricewhen OC gt 0, less adjustments.
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Transfer pricing Crossville Company
At practical capacity, the Fabricating Division
of Crossville Company has facilities to produce
8,000 units per month. Each unit requires five
direct labor hours. The Assembly Division has
forwarded a requisition for 8,000 units to the
Fabricating Division. Since Crossville uses a
market-based transfer pricing system,
contribution margin using a 50 market price
would be 168,000. Georges, Inc., a competitor,
also sells the units for 50. The receipt of this
requisition from Assembly upset the Fabricating
manager as he had just been approached by an
outside buyer with a rush order for 5,000 units
at a 56 unit selling price. Top managements
initial reaction is to reject the offer.
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Crossville Company
A. Does top management have a transfer pricing
policy?
B. What is the minimum transfer price required
by theselling division, Fabricating?
C. What is the maximum transfer price required
by thebuying division?
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Crossville Company
D. Will the two division managers agree to the
transfer?
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Crossvillle Company
Which of the following circumstances will leadto
goal congruence between the managers and
theoverall firm? Why?
1. The policy enforced is market price transfers.
Will the managers agree to transfer?
Is the transfer in the best interest of the
company?
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Crossville Company
Is the transfer in the best interest of the
company?
Minimize costs
Internal transfer
The company does not want an internal transfer.
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Crossville Company
2. Fabricating has adequate idle capacity.
This means that there is no meaningful market
pricefor the items that would be transferred.
What price will the Fabrication manager ask?
What price will the Assembly manager be willing
to pay?
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Crossville Company
3. Fabricating is forced to transfer product in
lieu ofselling 5,000 units outside.
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Negotiated market-based prices

• Some form of outside market for the intermediate
  product.
• Sharing of all market information among the
  negotiators.
• Freedom to buy or sell outside. This provides
  the necessary discipline to the bargaining
  process.
• Support and occasional involvement of top
  management.

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Its limitations

• Time consuming
• Leads to conflict within firms
• It makes the measurement of divisional
  profitability sensitive to the negotiating skills
  of managers.
• It requires the time of top management to oversee
  and mediate.
• It may lead to a sub-optimal level of output.

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Profit centers HCC Industries

• Participatory budgeting
• Setting budget performance targets
• Risk sharing and risk setting
• Communicating using the budget
• There are no actual calculations to do for HCC
  Industries
• Pay attention to the probabilities that are
  tossed about.