Transfer pricing
6 maggio 2008
1
Horizontal dimension at the business unit level
•
Business units as independent units which have the responsibility on one
product/market
• To evaluate the economic behavior of BU the top management has to solve
the following problems:
1. the definition of partial Profit/Loss statements for Business Unit;
2. the evaluation of possible internal trade (goods/services) between business
units (transfer pricing determination).
2
Transfers within the company
•
A transfer is referred to the movement of goods from a responsibility
center to another, within the same company
•
Different types of responsibility center, belonging to different
organizational levels, are involved in the transfers
3
Transfers within the company: the profit
centers
•
•
•
•
•
If the manager of a responsibility center is allowed to sell the produced
part (intermediate product) also to outside customers (he is not obliged
to sell the part exclusively to another company center), its
responsibility center is a profit center (the manager has the
responsibility both on costs and revenues)
The manager of a profit center must choose between the alternative of
selling outside or transferring the part within the company (which
customer, external or internal, is giving the higher price?)
The manager which uses the intermediate product must choose
between the alternative of purchasing it from outside supplier or from
an internal unit (which supplier, internal or external, is giving the lower
cost?)
If the transfer is not obliged (from a profit center) its value is called
“transfer pricing”
The problem is: how transfer prices should be defined?
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Transfers within the company: top
management and division managers
•
Top management wants to have information about the transfers
between profit centers because he wants to have the maximum overall
company profit;
•
Due to the fact that “transfer pricing” provides a rule for sharing
transfer extra-profit between division managers, these managers are
interested in its definition
•
A specific tool is available to have the relevant information about
internal transfer. The tool is called “Transfer Pricing Matrix”
•
The same result is obtainable through the application of the make-orbuy data analysis
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Optional transfers between profit centers:
which transfer price?
•
•
•
We use the following example: Yard Equipment Company and its
responsibility centers: Braxton and Clipper units
1° case: Braxton produces engines. It is a profit center: it is not
obliged to transfer engines to Clipper division and can sell engines
outside in the market; Clipper division is a profit center as well.
The question is: which is the value used for the transfer?
External customers
Braxton
Engines
Clipper
Finished product
(grass-cutting machine)
Ouside market of
finished product
External customers
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Optional transfers between profit centers:
which transfer price?
•
Transfer price is an internal price for optional transfers of an
intermediate product from a profit center to another profit center
•
Both the managers of the selling unit and the buying unit must agree on
the transfer
Anyway, the transfer is convenient only if the overall company profits are
increasing
•
• Three are the studied situations:
1. Braxton has available capacity in excess to realize the internal transfer to
Clipper
2. Braxton has not capacity in excess
3. Differential fixed costs are generated by the internal transfer
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1. Optional transfers from profit centers:
available capacity
•
•
•
•
Braxton is selling 100 engines to outside customers at price per unit=$300
Braxton has capacity of producing 150 engines monthly
Clipper manager wants to buy 50 engines and not more, so that Braxton
capacity is sufficient to realize the transfer to Clipper without abandoning the
external sales
The Braxton and Clipper data are the following:
Braxton division
Standard costs
Per unit
Total
Variable costs (for external sales)
Production costs
Other variable costs (sales & administration)
Total variable costs
Internal variable costs
Production costs
Other variable costs (sales & administration)
Total costs
Selling price to outside customers
$100
$90
$190
$10000
$9000
$19000
$100
$75
$175
$300
Clipper division
Purchasing price from ouside suppliers
$275
Other grass-cutting machine production costs $140
Grass-cutting machine selling price
$600
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1. Optional transfers from profit centers:
available capacity
•
•
•
•
Braxton is saving variable sale costs for $15 if it transfers engines to Clipper
Clipper manager has two alternatives: to buy engines from the outside
supplier at $275 or to buy engines from Braxton. He wants to obtain the
lower cost engine, so that his superior limit of price for the internal transfer
is $275 (he obviously accepts any lower price)
Braxton manager wants an internal price so that he can maintain his already
achieved contribution margin. If Braxton has capacity in excess the
alternatives are: to sell 50 engines to Clipper or not to produce these
engines due to the fact that there are not any other external customers.
Consequently, the internal transfer price must cover at least the internal
standard variable costs ($175). Obviously, Braxton manager accepts any
other higher price. Anyway, $175 is the inferior limit of price for the internal
transfer
Yard Equipment Company wants to obtain the engines at the lower costs.
The overall company has two alternatives: to produce 50 extra engines in
the Braxton division or to buy these motors for Clipper division from an
outside supplier at $275. Obviously the overall company prefers the internal
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transfer because it manages to save $100 per engine
1. Optional transfers from profit centers:
available capacity
•
The convenience (extra-profit or cost saving) for Yard Equipment Company
is obtainable from the difference between the maximum price (determined
by Clipper) and the minimum price (determined by Braxton)
Transfer price range
Max (by Clipper)
Min (by Braxton)
Variable costs saved with the transfer (extraprofit for Yard Company)
•
Excess of capacity
External purchasing price $275
Internal variable cost
$175
Max-Min
$100
GENERAL RULE: a transfer price range is so existing, acceptable for both the
managers. If the superior limit (max price for buying division) is higher than
the inferior limit (min price for selling division), Yard Equipment Company
has got always extra-profit from the transfer, if the selling division has
capacity in excess. Both the managers should agree to realize the transfer
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2. Optional transfers from profit centers:
not available capacity
•
Braxton is saturating his capacity with the external sales (150 engines, all
sold to external customers). Its inferior limit is different because its
alternatives are different: to sell all the engines to outside customers or to
transfer a part of them (50) to Clipper. In this case, achieving the breakeven means maintaining the same contribution margin obtainable by the
external sales
Selling price to outside customers
Variable costs
Contribution margin for engine
•
•
External sales
$300
$190
$110
Proposed internal transfer
Inferior limit of price
$175
$110
Inferior limit=$175+$110=$285
Alternatively we can derive the Inferior limit if the capacity is saturated (by
selling division) as= Normal Selling price ($300) - Normal Variable costs
saved with the internal transfer ($15)= $285
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2. Optional transfers from profit centers:
not available capacity
•
•
Clipper division has again a superior limit of price of $275 (engine price from
external supplier). It is not influenced by the level of Braxton capacity
Yard Equipment Company saves costs of $100 (internal production, $175,
respect to external purchasing price, $275), but it loses a contribution
margin of $110 for each engine not sold to outside customers. Consequently,
Yard has a net loss of $10 for each transferred engine. In fact, the different
between the superior limit of price (by buying division), $275, and the
inferior limit of price (by selling division), $285, is negative,
-$10
Transfer price range
Max (by Clipper)
Min (by Braxton)
Differential contribution margine for engine (for
Yard Company)
No Excess of capacity
External purchasing price $275
Internal variable cost
$285
Max-Min
($10)
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Optional transfers from profit centers: the
transfer pricing matrix
•
To compare the two situations the tool is the Transfer pricing Matrix. It gives
to the managers the relevant information to decide about the internal
transfer
Transfer price range
Max (by Clipper)
Excess of capacity
No Excess of capacity
External purchasing price External purchasing price
$275
$275
Icv+Cmu=Normal Selling
price-variable costs saved
Internal variable cost
$285 ($175+$110; $300$175
$15)
Min (by Braxton)
Differential contribution margine for engine (for
Yard Company)
$100
($10)
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3. Optional transfers from profit centers:
differential fixed costs
•
Suppose that Braxton has to occur additional fixed costs to produce engines
for Clipper because Clipper wants 20 engines with specific features (ex. with
a particular name printed above). Braxton has to buy a specific printing
machine for $1000, not usable for normal engines. The internal transfer
generates differential fixed costs. The transfer pricing matrix is so modified
(fixed costs as a total):
Transfer price range
Max (by Clipper)
Min (by Braxton)
Differential contribution margine for engine (for
Yard Company)
Special Transferred engines
Total contribution margin
Differential total fixed costs
Net profit for transfer
Excess of capacity
No Excess of capacity
External purchasing price External purchasing price
$275
$275
Icv+Cmu=Normal Selling
price-variable costs saved
Internal variable cost
$285 ($175+$110; $300$175
$15)
$100
20
$2000
$1000
$1000
($10)
20
($200)
$1000
($1200)
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3. Optional transfers from profit centers:
how is modified the transfer pricing
matrix with differential fixed costs
•
fixed costs as amount per unit:
Transfer price range
Max (by Clipper)
Excess of capacity
No Excess of capacity
External purchasing price External purchasing price
$275
$275
Icv+Cmu+Dfc=$175+$110
Ivc+Dfc=$175+$50=$225 +$50=$335
Min (by Braxton)
Differential contribution margine for engine (for
Yard Company)
$50
Special Transferred engines
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Net profit for transfer
$1000
($60)
20
($1200)
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Optional transfers from profit centers: the
choose of the transfer pricing and the
sharing of the profits
•
Use of the superior limit of price (transfer price=$275)
considering the situation of capacity in excess, all the transfer extra-profits
$100 are associated to Braxton division (Transfer pricing $275 - Internal
variable costs $175=$100); Clipper manager is indifferent respect the
external or internal buying
•
Use of the inferior limit of price (transfer price=$175)
all the transfer profits are associated to Clipper division
•
Use of the average point in the interval (transfer price=$225)
the transfer profits are shared in equal parts between the two division
($225-$175=$50 for Braxton; $275-$225=$50 for Clipper)
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Optional transfers from profit centers: not
available capacity and incremental fixed cost
•
GENERAL FORMULA for Inferior limit (by selling division) is as follows:
Ivc= Variable internal costs
Cmu= Contribution margin per unit of product, lost due to the fact the selling
division has not sold to outside customers
Dfc= Differential fixed cost for unit of product, if it exists, generated by the
internal transfer (look at the 3° situation)
Inferior limit of price=Ivc+Cmu+Dfc
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Optional transfers from profit centers: the
choose of the transfer pricing and the
sharing of the profits
•
Transfer pricing is only a rule for sharing transfer extra-profit between
division managers; any transfer price is at the end chosen, the overall
company extra-profit derived from the transfer does not change
•
The transfer overall profit is equal to the difference between the superior
limit of price (by buying division) and inferior limit of price (by selling
division). Each price is fixed, in fact, the sum of division profits is always
equal to the company overall profit derived by the transfer
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Optional transfers from profit centers:
who should decide the transfer pricing?
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•
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If managers of divisions are not evaluated and rewarded on the base of the
transfer extra-profit, there is no real conflict in the transfer pricing fixing.
The controller can decide the level of transfer pricing without particular
conflicts
If managers are evaluated and rewarded on the base of the profit derived
by internal transfer, there is a potential great conflict related to the transfer
price fixing. The internal transfer can be compromised even if the overall
company profit is increasing because managers of divisions do not agree
about the profit sharing. Different options can be followed by controller:
- fixing a transfer price, declaring the sharing of profit. The established
price is sometimes useful to save taxes at the overall company level
moving profits from higher tax rate countries to lower tax rate countries
- requiring the transfer, but not fixing a transfer price, asking that the
managers negotiate it (long time could be necessary in this case, but the
managers “accept” the transfer)
anyway, you realize that the transfer pricing problem is very hard in the
modern management control systems
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Obliged transfers from cost centers
•
•
2° case: Braxton unit is a cost center (it is obliged to transfer engines
to Clipper division that is a profit center. Braxton cannot sell engines
outside)
The question is: which is the value used for the transfer?
Other division
Braxton
Engine
Clipper
Finished product
(grass-cutting machine)
Ouside market of
finished product
Other division
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Obliged transfers from cost centers:
alternative value options
Monthly data (May)Standard costs
Per unit
Total
Variable costs
$100
$10000
Fixed costs
$80
$8000
Total costs
$180
$18000
Production volume 100 engines
Actual costs
Per unit
$110
$90
$200
Total
$11000
$9000
$20000
1. Transfer at cost: which cost? (actual/standard, full/variable)
2. Transfer at market price
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Obliged transfers from cost centers:
which cost?
•
•
1.
2.
3.
Braxton shows a negative variance both in the variable costs ($10 per
engine) and in the fixed costs ($10 per engine) for a total negative variance
of $20 per engine ($20*100 engines=$2000 total)
If the actual cost is used as transfer cost, overall Yard Equipment Company
could have problems in terms of:
Braxton manager has not incentive to control costs because he realizes that
any actual cost will be transfer to the Clipper Division ($20 are hidden in the
grass-cutting machine costs)
It could be difficult to evaluate each manager performance. Obviously,
Clipper manager is not available to accept the variance in his evaluation of
performance. If other components are transferred on the base of actual
cost, the total cost of finished product includes all the variances.
Consequently it is very difficult to find the responsibilities and to evaluate
the performances
Clipper manager has problems in forecasting his costs. In fact, he knows the
engine cost only at the actual transfer moment. It could be late for changing
the final price of the product to take into consideration the major engine
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cost
Obliged transfers from cost centers:
which cost?
•
If the standard cost is used as transfer cost ($18000=transferred costs,
$2000=variance at the Braxton cost center):
1. Braxton manager has incentive to control costs because his evaluation is
based on the obtained variances
2. Clipper manager is able to do better forecasting about his production costs
• Standard cost: variable or full?
1. If full cost is used as transfer price, it is possible to determine a more
appropriate selling price for the finished product (cost + mark-up). In
addition, the variance about fixed costs is correctly associated to the Braxton
manager(“right evaluation”).
2. If variable cost is used, the fixed costs are not included in the transfer costing
of the engine. The fixed costs will be charged to the cost of sold goods as an
overall sum. In this way the referring to the cost centers responsible for the
variances is lost.
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Obliged transfers from cost centers:
which cost?
•
•
If outside suppliers are existing and Clipper division can buy from them, a
market price is available as transfer costing
Market price represents the “opportunity cost” to obtain the engines, but it
does not represent a real cost. In fact, if the market price is used as transfer
price, the cost of grass-cutting machine could be over-evaluated in the case
the engine cost of Braxton is lower than the market price (=$250)
Clipper grass-cutting machine costs
Per unit
$250
$140
Total
$25000
$14000
$9000
$48000
Per unit
Braxton engines
$200
Other variable costs for Clipper finished product $140
Fixed costs
Manufacturing total costs
Total
$20000
$14000
$9000
$43000
Engines from Braxton
Other variable costs for finished product
Fixed costs
Manufacturing total costs
Yard Equipment Company Actual costs
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Obliged transfers from cost centers:
which cost?
•
•
•
1.
2.
Yard Equipment Company saves costs due to the fact Braxton division
produces engines ($250 -$200)*100 engines=$5000
But, since Braxton division cannot sell engines to outside customers, the
positive variance is only an unreal profit (a “dummy profit”) for Braxton
division and a major cost for Clipper division
In the reality, a market price is sometimes used, creating an unreal profit in
the statement of the supplier-division. Possible reasons are the following:
Taxes implications for the multinational companies. If, for example, the
engine cost production is lower in Mexico than in California (lower costs of
labor), and the Braxton production is consequently made in Mexico, the
resulting cost of grass-cutting machine in California should be lower and the
taxes on income higher. If the California tax-rate is major than Mexico taxrate, it is convenient to use the $250 market price to bring the $5000 profit
to Braxton division in Mexico. This profit moving allows Yard Equipment
Company to really save costs for taxes.
Creation of a responsibility on profit. As a first step towards the
transformation of a cost center into a profit center
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