ACC3602

Managerial Planning and Control

Semester II, AY 2014/15
Instructor:Dr.ZhuZinan
Email:bizzz@nus.edu.sg
Office:BIZ1#724

Lecture 3
Transfer Pricing
RelevantChapters:

MerchantandVanderStede,ManagementControlSystems:
PerformanceMeasurement,Evaluation,andIncentives,
Chapter7

LearningObjectives:
1.
Whatistransferpricinganditspurposes
2.
Transferpricingalternatives
3.
Ageneralguidelinefortransferpricingsituations
4.
Multinationaltransferpricingandtaxconsiderations

1. What is transfer pricing?

Thepriceatwhichproductsorservicesaretransferred
betweenprofitcenterswithinthesamefirm

Batteries

BatteryDivision

AutoDivision

Intermediateproducttheproductorservice
transferredbetweensubunitsofanorganization.
3

1. What is transfer pricing?

Itaffectstherevenuesoftheproducingprofitcenter(PC),
thecostsofthebuyingPC,and,hence,theprofitsofboth
entities
A higher transfer
price for batteries
means . . .

BatteryDivision

greater
profitsforthe
batterydivision.

AutoDivision
lower profits
forthe
autodivision.
4

1. What is transfer pricing?

Purposes
Focusmanagersattentionontheperformanceoftheirown
subunitsandprovideinformationforevaluatingPCperformance
Planandcoordinatetheactionsofdifferentsubunitsto
maximizethecompanysincomeasawhole
Purposelymoveprofitsbetweencompanyentities/locations

2. Transfer pricing alternatives

Marketbasedtransferprices
Costbasedtransferprices
Marginalcosts(proxiedbyvariableordirectcosts)
Fullcosts
Fullcostsplusamarkup

Hybridtransferprices
Dualpricing
Negotiatedpricing

2. Transfer pricing alternatives: An Illustration

HorizonPetroleumhastwodivisions,eachoperatingas
aprofitcenter.Thetransportationdivisionpurchases
crudeoilinMatamoros,Mexico,andtransportsitfrom
MatamorostoHouston,Texas.Therefiningdivision
processescrudeoilintogasoline.Forsimplicity,we
assumegasolineistheonlysalableproductthe
Houstonrefinerymakesandthatittakestwobarrelsof
crudeoiltoyieldonebarrelofgasoline.

2. Transfer pricing alternatives: An Illustration

Another
producer
@85
@72
Matamoros,
Mexico

Transportation
40,000

20,000
@190

Refining

10,000
Transportation
VC/oil=1
FC/oil=3
Fullcost=4

Refining
VC/gas=8
FC/gas=6
Fullcost=14
30,000barrels
ofcrudeoil

Gasolinesoldto
external

2. Transfer pricing alternatives: Market-based TP

Topmanagementchoosestousethepriceofsimilarproductorservice
thatispubliclyavailable.Sourcesofpricesincludetradeassociations,
competitors,andsoon.
Actualprice,whichischargedtoexternalcustomers,listedpriceofa
similarproduct,orthepriceacompetitorisoffering(bidprice)
Deviations canbeallowedthatreflectdifferencesbetweeninternaland
externalsales:e.g.,savingsinmarketing,selling,andcollectingcosts;
differencesinqualitystandards,specialfeatures,orspecialservices
provided

Thesellingdivisionmayelecttotransferortocontinuetoselltothe
outside.
ManagersofboththesellingandbuyingPCwillmakedecisionsthatare
optimalfromacorporateperspective,andreportsoftheir
performanceswillprovidegoodinformationforevaluationpurposes.

2. Transfer pricing alternatives: Marginal cost TP

Usuallyproxiedbyvariableordirectcosts

Itprovidespoorinformationforevaluationpurposes
ThesellingPCincursaloss
TheprofitsofthebuyingPCareoverstated

Rarelyusedinpractice

Variation:Marginalcost+lumpsumfee
Themarginalcostofthetransferremainsvisible
ThesellingPCcanrecoveritsfixedcostandaprofitmargin
throughthelumpsumfee
Problem:mustpredeterminethelumpsumfeebasedonan
estimateofthecapacitythateachinternalcustomerwill
requireintheforthcomingperiod.

2. Transfer pricing alternatives: Full cost TP

Popularinpractice
Relativelyeasytoimplement
Firmshavecostsystemsinplacetocalculatethefullcostof
production
But,fullcostsrarelyreflectactual,currentcostsof
producingtheproductsbecauseoffinancialaccounting
conventions(e.g.,depreciation)andarbitraryoverheadcost
allocations

ThereisnoincentiveforthesellingPCtotransfer
internallysincethereisnoprofitmargin
TheprofitofthesellingPCisunderstated

2. Transfer pricing alternatives: Full cost plus a markup

Itprovidesameasureoflongrunviability.
ItallowsthesellingPCtoearnaprofiton
internallytransferredproducts/services
Italsoprovidesacrudeapproximationofthe
marketpriceincaseswherenocompetitive
externalmarketpriceexists.Suchtransfer
prices,however,arenot(quite)responsiveto
marketconditions.
Say105%offullcost

2. Transfer pricing alternatives: An Illustration

Another
producer

Gulfmex Corp.
Mexico
@79 20,000
@72
Matamoros,
Mexico

Transportation
40,000

@85

20,000
@190

Refining

10,000
Transportation
VC/oil=1
FC/oil=3
Fullcost=4

Refining
VC/gas=8
FC/gas=6
Fullcost=14
30,000barrels
ofcrudeoil

Gasolinesoldto
external

2. Transfer pricing alternatives: Dual-rate TP

Dualpricingusingtwoseparatetransferpricing
methodstopriceeachtransferfromonesubunitto
another.
ThesellingPCiscreditedwiththeoutsidesalesprice
ThebuyingPCischargedthemarginal(orfull)costof
productiononly
Thedifferenceischargedtoacorporateaccountand
eliminatedatthetimeoffinancialstatement
consolidation

2. Transfer pricing alternatives: Dual-rate TP

Advantages
Itprovidespropereconomicsignalsfordecisionmaking
Itensuresthatinternaltransactionswilltakeplace

Disadvantages
Itdestroysincentivestonegotiatefavorableoutside
pricesforsupplies(buyingPCnowonlypaysthe
marginalorfullcost)
Itdestroysincentivestoimproveproductivity(selling
PCfindseasysalesinside)

15

2. Transfer pricing alternatives: Negotiated TP

Transferpricesarenegotiatedbetweentheselling
andbuyingPCmanagersthemselves
BothPCmanagersshouldhavesomebargainingpower
(i.e.,somepossibilitiestosellorsourceoutside)
Theoutcomeisoftennoteconomicallyoptimal,butrather
dependsonthenegotiatingskillsofthemanagersinvolved

Itiscostly(managementtime),accentuatesconflicts
betweenPCmanagers,andoftenrequirescorporate
managementintervention.

3. A general guideline for transfer pricing situations

Thereisgenerallyarangeof
possibletransferpricesthat
wouldinducegoalcongruence.
Upperlimit(maximumtransfer
price):setbythebuyingdept.

RangeofAcceptableTransfer
Prices
Upperlimitis
determinedby
thebuying
division.

Transferprice<=costofbuyingfrom
outsidesupplier

Lowerlimit(minimumtransfer
price):setbythesellingdept.
Transferprice>=apricedetermined
bya generalguideline

Lowerlimitis
determinedby
theselling
division.

17

3. A general guideline for transfer pricing situations

Minimum
Transfer
price

Incrementalcostperunit
incurredbecausegoods
aretransferred

Opportunitycost
perunittothe
sellingsubunit

Theincrementalcostinthis
contextmeanstheadditionalcost
ofproducingandtransferringthe
productorservice.
Includedirectvariablecostsofthe
productorserviceandanyother
outlaycoststhatareincurredonly
asaresultofthetransfer.

OChereisthemaximumCM
forgonebythesellingsubunitif
transferredinternally.
Forexample,onedivisionsells
goodstotheotherdivisioninstead
ofsellingtotheexternalmarket.
OC=thecontributionmarginlost
onexternalsalesgivenup.

Totalcontributionmarginonlostsales(external)
Numberofunitstransferredinternally18

3. A general guideline for transfer pricing situations

Considerthefollowingscenarios:
Aperfectcompetitivemarketfortheintermediate
productexists,andthesellingdivisionhasno
unusedcapacity.
Thesellingdivisionhasunusedcapacity.
Nomarketexistsfortheintermediateproduct(i.e.,
thecrudeoiltransportedbyTransportationcouldbe
usedonlybyRefiningandwouldnotbewantedby
externalparties.)

4. Multinational transfer pricing and tax considerations

Sincetaxratesandimportdutiesaredifferentin
differentcountries,companieshaveincentivesto
settransferpricesthatwill:
Increaserevenuesinlowtaxcountries.
Increasecostsinhightaxcountries.
Reducecostofgoodstransferredtohigh
importdutycountries.
E.g.,Googletransferredrevenuesfromcustomersin
BritaintoGooglesEuropeanheadquartersinDublin.By
payingthelowIrishcorporatetaxrateof12.5%,Google
saved450millioninUKtaxesin2009alone.
20

4. Multinational transfer pricing and tax considerations

Whengoodsorservicesaretransferredbetweendivisionsofacompany
thatarelocatedindifferentcountries,thecompanymayhaveanincentive
tosettransferpricestominimizetheoveralltaxexposureofthecompany.
Andthisincentivemaybesostrongthatitoverridestheapproachesto
settingtransferpricesdiscussedearlier.
AccordingtoasurveybyErnst&YoungLLP,transferpricingisthetoptax
issuefacingmultinationalcorporations. Oftheinternationaltaxdirectors
at582multinationalorganizationspolledinthesurvey,75percentexpect
theircompanytofaceatransferpricingauditwithinthenexttwoyears.
Taxlawsvaryamongcountrieswithregardtoflexibilityinsettingtransfer
prices.Becauseofthepotentialforlossoftaxrevenue,mostcountries
withrelativelyhightaxrateshavelawsprohibitingthebehaviordescribed
inourexample.

21

EndofLecture3

22