The Fuqua School of Business Duke University International Strategy WBA 434 Professors Heath Huddart Slotta Transfer Pricing 1 Overview An essential feature of decentralized firms is responsibility centers e g cost profit revenue or investment centers The performance of these responsibility centers is evaluated on the basis of various accounting numbers such as standard cost divisional profit or return on investment as well as on the basis of other non accounting measures like market share One function of the management accounting system therefore is to attach a dollar figure to transactions between different responsibility centers The transfer price is the price that one division of a company charges another division of the same company for a product transferred between the two divisions The basic purpose of transfer pricing is to induce optimal decision making in a decentralized organization i e in most cases to maximize the profit of the organization as a whole Profit Center 2 2 1 Any sub unit of an organization that is assigned both revenues and expenses In a profit center a manager is treated as an entrepreneur Typically a profit center manager is given decision making power and is held responsible for the profits generated by her center Advantages and Disadvantages of Decentralization Advantages Decisions are better and more timely because of the manager s proximity to local conditions Top managers are not distracted by routine local decision problems Managers motivation increases because they have more control over results Based on a note by Nahum Melumad c Heath Huddart Slotta 2009 All rights reserved www personal psu edu sjh11 WBA 434 International Strategy Transfer Pricing Increased decision making provides better training for managers for higher level positions in the future 2 2 Disadvantages Lack of goal congruence among managers in different parts of the organization Insufficient information available to top management increased costs of obtaining detailed information Lack of coordination among managers in different parts of the organization 3 Purposes of Transfer Pricing There are two main reasons for instituting a transfer pricing scheme Generate separate profit figures for each division and thereby evaluate the performance of each division separately Help coordinate production sales and pricing decisions of the different divisions via an appropriate choice of transfer prices Transfer prices make managers aware of the value that goods and services have for other segments of the firm Transfer pricing allows the company to generate profit or cost figures for each division separately The transfer price will affect not only the reported profit of each center but will also affect the allocation of an organization s resources 4 Mechanics of Transfer Pricing No money need change hands between the two divisions The transfer price might only be used for internal record keeping Transfer Price quantity of goods exchanged is an expense for the purchasing center and a revenue for the selling center Page 2 Transfer Pricing 5 International Strategy WBA 434 Accounting for Transfer Pricing If intra company transactions are accounted for at prices in excess of cost appropriate elimination entries should be made for external reporting purposes Examples of items to be eliminated for consolidated financial statements include Intracompany receivables and payables Intracompany sales and costs of goods sold Intracompany profits in inventories 6 Alternative Methods of Transfer Pricing A transfer pricing policy defines rules for calculating the transfer price In addition a transfer price policy has to specify sourcing rules i e either mandate internal transactions or allow divisions discretion in choosing whether to buy sell externally The most common transfer pricing methods are described below 6 1 Market based Transfer Pricing When the outside market for the good is well defined competitive and stable firms often use the market price as an upper bound for the transfer price Concerns with market based Transfer Pricing When the outside market is neither competitive nor stable internal decision making may be distorted by reliance on market based transfer prices if competitors are selling at distress prices or are engaged in any of a variety of special pricing strategies e g price discrimination product tie ins or entry deterrence Also reliance on market prices makes it difficult to protect infant segments 6 2 Negotiated Transfer Pricing Here the firm does not specify rules for the determination of transfer prices Divisional managers are encouraged to negotiate a mutually agreeable transfer price Negotiated transfer pricing is typically combined with free sourcing In some companies though headquarters reserves the right to mediate the negotiation process and impose an arbitrated solution Page 3 WBA 434 International Strategy 6 3 Transfer Pricing Cost based Transfer Pricing In the absence of an established market price many companies base the transfer price on the production cost of the supplying division The most common methods are Full Cost Cost plus Variable Cost plus Lump Sum charge Variable Cost plus Opportunity cost Dual Transfer Prices Each of these methods is outlined below 6 3 1 Full Cost A popular transfer price because of its clarity and convenience and because it is often viewed as a satisfactory approximation of outside market prices i Full actual costs can include inefficiencies thus its usage for transfer pricing often fails to provide an incentive to control such inefficiencies ii Use of full standard costs may minimize the inefficiencies mentioned above 6 3 2 Cost plus When transfers are made at full cost the buying division takes all the gains from trade while the supplying division receives none To overcome this problem the supplying division is frequently allowed to add a mark up in order to make a reasonable profit The transfer price may then be viewed as an approximate market price 6 3 3 Variable Cost plus a Lump Sum Charge In order to motivate the buying division to make appropriate purchasing decisions the transfer price could be set equal to standard variable cost plus a lump sum periodical charge covering the supplying division s related fixed costs Page 4 Transfer Pricing 6 3 4 International Strategy WBA 434 Variable Cost plus Opportunity Cost Also know as the Minimum Transfer Price Minimum Transfer Price Incremental Cost Opportunity Cost For internal decision