Sei sulla pagina 1di 22
ACC3602 Managerial Planning and Control Semester II, AY 2014/15
ACC3602
Managerial Planning and Control
Semester II, AY 2014/15

Instructor: Dr. Zhu Zinan Email: bizzz@nus.edu.sg Office: BIZ1 #7 24

Lecture 3 Transfer Pricing
Lecture 3
Transfer Pricing

Relevant Chapters:

Merchant and Van der Stede, Management Control Systems:

Performance Measurement, Evaluation, and Incentives, Chapter 7

Learning Objectives:

1. What is transfer pricing and its purposes

2. Transfer pricing alternatives

3. A general guideline for transfer pricing situations

4. Multinational transfer pricing and tax considerations

1. What is transfer pricing?
1. What is transfer pricing?

The price at which products or services are transferred between profit centers within the same firm

between profit centers within the same firm Battery Division Batteries Auto Division Intermediate
between profit centers within the same firm Battery Division Batteries Auto Division Intermediate

Battery Division

Batteries

centers within the same firm Battery Division Batteries Auto Division Intermediate product—the product or
centers within the same firm Battery Division Batteries Auto Division Intermediate product—the product or

Auto Division

Intermediate product—the product or service transferred between subunits of an organization.

1. What is transfer pricing?
1. What is transfer pricing?

It affects the revenues of the producing profit center (PC), the costs of the buying PC, and, hence, the profits of both entities

buying PC, and, hence, the profits of both entities Battery Division A higher transfer price for
buying PC, and, hence, the profits of both entities Battery Division A higher transfer price for
buying PC, and, hence, the profits of both entities Battery Division A higher transfer price for

Battery Division

hence, the profits of both entities Battery Division A higher transfer price for batteries means Auto

A higher transfer price for batteries means

Division A higher transfer price for batteries means Auto Division greater profits for the battery
Division A higher transfer price for batteries means Auto Division greater profits for the battery

Auto Division

A higher transfer price for batteries means Auto Division greater profits for the battery division. lower

greater profits for the battery division.

lower profits for the auto division.

1. What is transfer pricing?
1. What is transfer pricing?

Purposes

Focus managers’ attention on the performance of their own subunits and provide information for evaluating PC performance

Plan and coordinate the actions of different subunits to maximize the company’s income as a whole

Purposely move profits between company entities/locations

2. Transfer pricing alternatives
2. Transfer pricing alternatives

Marketbased transfer prices

Costbased transfer prices

based transfer prices • Cost ‐ based transfer prices – Marginal costs (proxied by variable or

Marginal costs (proxied by variable or direct costs)

Full costs

Full costs plus a markup

costs) – Full costs – Full costs plus a markup • Hybrid transfer prices – Dual

Hybrid transfer prices

Dual pricing

Negotiated pricing

Full costs – Full costs plus a markup • Hybrid transfer prices – Dual pricing –
2. Transfer pricing alternatives: An Illustration
2. Transfer pricing alternatives: An Illustration

Horizon Petroleum has two divisions, each operating as a profit center. The transportation division purchases crude oil in Matamoros, Mexico, and transports it from Matamoros to Houston, Texas. The refining division processes crude oil into gasoline. For simplicity, we assume gasoline is the only salable product the Houston refinery makes and that it takes two barrels of crude oil to yield one barrel of gasoline.

2. Transfer pricing alternatives: An Illustration
2. Transfer pricing alternatives: An Illustration
Another producer
Another
producer

@85 20,000

@190

@72

Matamoros, Transportation Mexico 40,000
Matamoros,
Transportation
Mexico
40,000

?

20,000 @190 @72 Matamoros, Transportation Mexico 40,000 ? Refining Gasoline sold to external 10,000 Transportation
Refining Gasoline sold to external
Refining
Gasoline sold to
external

10,000

Transportation VC/oil = 1 FC/oil = 3 Full cost = 4
Transportation
VC/oil = 1
FC/oil = 3
Full cost = 4
Refining VC/gas = 8 FC/gas = 6 Full cost = 14 30,000 barrels of crude
Refining
VC/gas = 8
FC/gas = 6
Full cost = 14
30,000 barrels
of crude oil
2. Transfer pricing alternatives: Market-based TP
2. Transfer pricing alternatives: Market-based TP

Top management chooses to use the price of similar product or service that is publicly available. Sources of prices include trade associations, competitors, and so on.

Actual price , which is charged to external customers, listed price of a similar product, or the price a competitor is offering ( bid price )

Deviations can be allowed that reflect differences between internal and external sales: e.g., savings in marketing, selling, and collecting costs; differences in quality standards, special features, or special services provided

The selling division may elect to transfer or to continue to sell to the outside.

Managers of both the selling and buying PC will make decisions that are optimal from a corporate perspective, and reports of their performances will provide good information for evaluation purposes.

2. Transfer pricing alternatives: Marginal cost TP
2. Transfer pricing alternatives: Marginal cost TP

Usually proxied by variable or direct costs

It provides poor information for evaluation purposes

The selling PC incurs a loss

The profits of the buying PC are overstated

Rarely used in practice

Variation: Marginal cost + lump sum fee

The marginal cost of the transfer remains visible

The selling PC can recover its fixed cost and a profit margin through the lump sum fee

Problem: must predetermine the lump sum fee based on an estimate of the capacity that each internal customer will require in the forthcoming period.

2. Transfer pricing alternatives: Full cost TP
2. Transfer pricing alternatives: Full cost TP

Popular in practice

Relatively easy to implement

Firms have cost systems in place to calculate the full cost of production

But, full costs rarely reflect actual, current costs of producing the products because of financial accounting conventions (e.g., depreciation) and arbitrary overhead cost allocations

There is no incentive for the selling PC to transfer internally since there is no profit margin

The profit of the selling PC is understated

2. Transfer pricing alternatives: Full cost plus a markup
2. Transfer pricing alternatives: Full cost plus a markup

It provides a measure of long run viability.

It allows the selling PC to earn a profit on internally transferred products/services

It also provides a crude approximation of the market price in cases where no competitive external market price exists. Such transfer prices, however, are not (quite) responsive to market conditions.

Say “105% of full cost”

2. Transfer pricing alternatives: An Illustration
2. Transfer pricing alternatives: An Illustration
Another Gulfmex Corp. Mexico producer @79 20,000 @85 20,000 @72 ? @190 Matamoros, Transportation Refining
Another
Gulfmex Corp.
Mexico
producer
@79 20,000
@85 20,000
@72
?
@190
Matamoros,
Transportation
Refining
Mexico
40,000
10,000
Gasoline sold to
external
Transportation VC/oil = 1 FC/oil = 3 Full cost = 4
Transportation
VC/oil = 1
FC/oil = 3
Full cost = 4
Refining VC/gas = 8 FC/gas = 6 Full cost = 14 30,000 barrels of crude
Refining
VC/gas = 8
FC/gas = 6
Full cost = 14
30,000 barrels
of crude oil
2. Transfer pricing alternatives: Dual-rate TP
2. Transfer pricing alternatives: Dual-rate TP

Dualpricing—using two separate transfer pricing methods to price each transfer from one subunit to another.

The selling PC is credited with the outside sales price

The buying PC is charged the marginal (or full) cost of production only

The difference is charged to a corporate account and eliminated at the time of financial statement consolidation

2. Transfer pricing alternatives: Dual-rate TP
2. Transfer pricing alternatives: Dual-rate TP

Advantages

It provides proper economic signals for decision making

It ensures that internal transactions will take place

Disadvantages

It destroys incentives to negotiate favorable outside prices for supplies (buying PC now only pays the marginal or full cost)

It destroys incentives to improve productivity (selling PC finds “easy” sales inside)

2. Transfer pricing alternatives: Negotiated TP
2. Transfer pricing alternatives: Negotiated TP

Transfer prices are negotiated between the selling and buying PC managers themselves

Both PC managers should have some bargaining power (i.e., some possibilities to sell or source outside)

The outcome is often not economically optimal, but rather depends on the negotiating skills of the managers involved

It is costly (management time), accentuates conflicts between PC managers, and often requires corporate management intervention.

3. A general guideline for transfer pricing situations
3. A general guideline for transfer pricing situations

There is generally a range of possible transfer prices that would induce goal congruence.

Upper limit (maximum transfer price): set by the buying dept.

Transfer price <= cost of buying from outside supplier

Lower limit (minimum transfer price): set by the selling dept.

Transfer price >= a price determined by a general guideline

Range of Acceptable Transfer Prices Upper limit is determined by the buying division. Lower limit
Range of Acceptable Transfer
Prices
Upper limit is
determined by
the buying
division.
Lower limit is
determined by
the selling
division.
3. A general guideline for transfer pricing situations
3. A general guideline for transfer pricing situations

Minimum

Incremental cost per unit incurred because goods are transferred

Opportunity cost per unit to the selling subunit

Transfer = price • The incremental cost in this context means the additional cost of
Transfer
=
price
• The incremental cost in this
context means the additional cost
of producing and transferring the
product or service.
• Include direct variable costs of the
product or service and any other
outlay costs that are incurred only
as a result of the transfer.
+ • OC here is the maximum CM forgone by the selling subunit if transferred
+
• OC here is the maximum CM
forgone by the selling subunit if
transferred internally.
• For example, one division sells
goods to the other division instead
of selling to the external market.
OC = the contribution margin lost
on external sales given up.
Total contribution margin on lost sales (external)
Number of units transferred internally
18
3. A general guideline for transfer pricing situations
3. A general guideline for transfer pricing situations

Consider the following scenarios:

A perfect competitive market for the intermediate product exists, and the selling division has no unused capacity.

The selling division has unused capacity.

No market exists for the intermediate product (i.e., the crude oil transported by Transportation could be used only by Refining and would not be wanted by external parties.)

4. Multinational transfer pricing and tax considerations
4. Multinational transfer pricing and tax considerations

Since tax rates and import duties are different in different countries, companies have incentives to set transfer prices that will:

Increase revenues in low tax countries.

Increase costs in high tax countries.

Reduce cost of goods transferred to high import duty countries.

E.g., Google transferred revenues from customers in Britain to Google’s European headquarters in Dublin. By paying the low Irish corporate tax rate of 12.5%, Google saved £450 million in UK taxes in 2009 alone.

4. Multinational transfer pricing and tax considerations
4. Multinational transfer pricing and tax considerations

When goods or services are transferred between divisions of a company that are located in different countries, the company may have an incentive to set transfer prices to minimize the overall tax exposure of the company. And this incentive may be so strong that it overrides the approaches to setting transfer prices discussed earlier.

According to a survey by Ernst & Young LLP, “transfer pricing is the top tax issue facing multinational corporations. Of the international tax directors at 582 multinational organizations polled in the survey, 75 percent expect their company to face a transferpricing audit within the next two years.”

Tax laws vary among countries with regard to flexibility in setting transfer prices. Because of the potential for loss of tax revenue, most countries with relatively high tax rates have laws prohibiting the behavior described in our example.

End of Lecture 3