AF6010

TRANSFER PRICING
 Relevant Reading

• Essential Reading – Drury, C, 2016, Management Accounting

for Business, Cengage: Chapter 13
• Further Reading: Drury, C, 2015, Management and Cost
Accounting, Cengage: Chapter 20
 TRANSFER PRICING
Quote ..
“Tax dodging companies are disinvesting in our country – not investing it
it.
Many US multi national companies use a gimmick called “transfer pricing”
– shifting patents to their offshore subsidiaries, for example – in order to pretend
they’ve earned their profits in a tax haven like the Cayman Islands, Bermuda or
Luxembourg, even though their operations there may be little more than a mail box.
What they’re really doing is transferring their US profits offshore and
transferring their tax responsibilities to the rest of us.”
Shanghai Daily, 15 September 2011
 TRANSFER PRICING
– Cooking the Books

• In 1999, Vaux Brewery reported profits of £1.2m

• Vaux was owned by Swallow group, who also owned hotels & pubs
• Swallow group set transfer prices for beer from the brewery to the hotels
and pubs
• Swallow group was sold at the end 1999. The new owners found that the
transfer prices were set so high, that if ‘Market Prices’ had been used, the
brewery would have made a £2.5m loss.
 What is Standard
TRANSFER Costing?
PRICING FLOWS CLIENTS

Group Manufacturing Plant

(China)

Transfer Price
Market Price

Group Commercial Entities

(Europe)
TRANSFER PRICING – what is it?
• It is the setting of price for goods and services rendered by
one division to another of the same company and may cover:
– Products
– Services
– Financial transactions, etc
• Applicable where divisions of a large organisation are treated
and performance evaluated as autonomous entities.
TRANSFER PRICING – what is it?
• An established Transfer Price is a cost for the buying
division and revenue for the selling division.
• Therefore it will effect the profitability of each division
• How we set the Transfer Prices will determine the
performance of each division.
What is Standard Costing?
TRANSFER PRICING (TP)
The problem of TP is how to attain several goals simultaneously.
The expectation is that where implemented effectively, it should:
• Induce optimal decision making in a decentralized organization
• Lead to efficient trade between divisions. Improve the profit of the
division, but also the profit of the whole organisation
• Facilitate performance evaluation for divisions and their managers. We
want to set a price that encourages all divisional managers to act in line
with the organisations strategy, including profit maximisation
 TRANSFER PRICING (TP)
…It should:
• Form the basis for setting up incentives and reward structure for managers
and motivate managers to make good economic decisions
• Forster goal congruence in the organisation – Employees should engage in
behaviour that aligned with the organisations strategy: Everyone pulling in
the same direction
REMINDER: Responsibility Centres
• Centralised: Control is maintained at the top – decisions made by
senior management
• Decentralised: Control of the decision making process is passed down
to divisional managers. The outcome:
o Independence of divisions
o Better quality decisions
o Quicker decisions
o More motivation of managers
o Allows senior management more time for strategic activities
REMINDER: Responsibility Centres

• Cost Centre: Controls Costs only

• Revenue Centre: Controls Revenue Only
• Profit Centre: Controls Revenue Only
• Investment Centre: Controls Investments, Revenues & Costs
REMINDER: Responsibility Centres

• Performance of responsibility centres is evaluated

based on various accounting number basis including,
standard cost, ROI, RI, budget, etc.
• There4 one of the functions of TP is to attach financial
figure to business transactions between responsibility
centres.
 TRANSFER PRICING
The Big Challenge

How can we set a transfer price that encourages

managers to:
o Act in line with strategy
o Be Motivated
o Allows for Performance Measurement
o While allowing for autonomy, but not act in the sole interests of their
division?
TRANSFER PRICING
Basic TP Methods

• Market – Based Price

• Cost Based Prices
• Negotiated Prices
 TRANSFER PRICING
MARKET BASED PRICE
This is perhaps the easiest and less complicated transfer pricing
approach, where a product’s market is well defined, competitive and
stable.
• With this approach, the selling division can sell internally or externally
and earn highest possible profit.
• May drive efficiency as both divisions are acting as if a market driven
situation
• However, this approach may make it difficult to protect newly
established subsidiaries.
• There may be no market for intermediate product.
• Market may be volatile
 TRANSFER PRICING
COST BASED PRICE

• Where there is no established market price, a company can base

the TP on the production cost of supplying subsidiary. Common
methods include:
– Full cost
– Full Cost/Variable Cost plus
– Variable cost plus opportunity cost
 TRANSFER PRICING
COST BASED PRICE
• FULL COST (FC)- Where NO external market exists for the product being
transferred, full cost can be used.
Problems
• However, FC can lead to dysfunctional behaviour. It may provide no incentive to
control inefficiencies which are then passed on to the buying division. To overcome
this, full standard cost may be used.
• Selling division makes no profit at all
• Feeling of ‘unfair’ treatment for Supplier & Buyer
• Difficult to assess divisional performance , particularly the buyer division
 Division K Division Q
Transferring Receiving
Division TransferDivision
(Selling) Price (Buying)
Transfer price - 40.00
EXAMPLE
Division's costs:
- Variable 25.00 12.00
- Fixed 15.00 18.00
Divisional profit/mark up - 10.00
Transfer out price/ final selling price 40.00 80.00

Assuming due to over capacity a special offer price of £40 is offered to

clear over production.

Required:
Compare the likely decisions of the headoffice and Division Q
regarding the special offer.
 EXAMPLE
• The Division Q manager will reject the special offer since the division’s
marginal cost is £52 (TP = £40 + £12 (own VC). The offer price gives
negative contribution of £12.
• The head office will like the offer accepted since the group marginal
cost is £37 [£25 (Div. K) + £12 (Div. Q)]. A special offer of £40
generates £3 positive contribution to the group.
• Head office may impose acceptance but Div. Q manager will resist it
since it compromised divisional autonomy principle, and the impact on
divisional performance.
 TRANSFER PRICING
COST BASED PRICE
• FULL COST / VARIABLE COST +: TP set at full or Variable cost plus
increases the TP by a mark-up.
• Will motivate the transferring division as it allows profit to be made possibly
in both the transferring and receiving divisions.
• Problems:
– Can create dysfunctional behaviour/decisions since buying division can make profit
maximising decision but which may not maximise group profit, particularly if the final selling
price falls.
– Both full cost+ and variable cost + approaches result in fixed costs and profits (mark-up)
being treated as marginal costs in receiving division. Therefore receiving division has wrong
data for economic decision for the group should it wish to.
– Mark up may lead to dysfunctional behaviour + how do you fix mark up?
TRANSFER PRICING
NEGOTIATED PRICE

• We allow divisional managers to negotiate a price

between them
• Can be used where some market imperfections exist
• Eliminates any bad feeling of unfairness
• Best where equal bargaining power exists
TRANSFER PRICING – It’s all company money
Div. A Div. B Gro up
Va ria b le c o st 10 8 18
Tra n sfe r c o st 0 18
Fixe d c o st 5 4 9
To ta l c o st 15 30 27
Ma rk up @ 20% 3
Se llin g p ric e 18 40 40

Pro fit 3 10 13
TRANSFER PRICING GUIDELINE
• Minimum Transfer Price – TP from Selling division’s position
• The minimum = Marginal Cost + Opportunity Cost (OC)
• i.e. the value of the best alternative foregone when a course of a action is taken.
• There will be opportunity cost if the seller is operating at full capacity (i.e. no spare
capacity available).

• Spare Capacity Situation

• For any sales made internally from spare capacity, the OC is Zero since workers and
machines are not fully utilised.
• No Spare Capacity Situation
• Market price, less any cost savings (e.g. from packaging).
TRANSFER PRICING GUIDELINE

• Maximum Transfer Price– TP from buyer division’s position

• The maximum price the buying division is willing to pay:
• = The market price of the product, i.e. whatever they would paid external
supplier.
• A reduction to reflect costs saved via internal trading will be expected and often
negotiated leading to what is known as adjusted market price.
• Drury, C, 2016, Management Accounting for Business, Cengage: Chapter 13
• Drury, C, 2015, Management and Cost Accounting, Cengage: Chapter 20
• McWatters, C. S., Zimmerman, J. L., Morse, D. C., 2008, Management Accounting
Analysis and Interpretation, Prentice Hall, Financial Times
• Scarlett, B., 2004, Opportunity Knocks, CIMA