Transfer Pricing

Chapter 19

Transfer price

Amount charged by one division selling goods/services to another division

Intra-organization transfer

Overall organization profit is unaffected

Transfer price will affect the profit of the divisions involved

Revenue to seller, cost to buyer

Transfer price

If seller/buyer have no other options

Transfer price is irrelevant to the organization

What is good for seller is bad for buyer and vice-versa

Seller’s revenue will equal buyer’s cost

Transfer price

If seller/buyer have options

Seller will sell to outsider if transfer price is below market price

Buyer will buy from outsider if transfer price is above market price

Overall organization’s profit will be affected

General rule

Transfer price calculated as

Additional outlay cost per unit

+ Opportunity cost per unit if transferred

Transfer price

General rule

No excess capacity

Would the Assembly Division sell to an external customer offering $95 per unit?

Producing Division$80 cost per unit100 unit capacity

External wholesale customers100 unit demand

$100 price

External retail customers$130 price

80 unit demand

Assembly DivisionTransfer price?

$20 per unit profit

$50 per unit profit

Producing Division$80 cost per unit500 unit capacity

External wholesale customers100 unit demand

$100 price

External retail customers$130 price

80 unit demand

Assembly DivisionTransfer price?

$20 per unit profit

$50 per unit profit

General rule

Excess capacity

Would the Assembly Division sell to an external customer offering $95 per unit?

Transfer based on external market price

Same result as the general rule if no excess capacity exists

If excess capacity exists

General rule results in a lower transfer price

Producing Division can sell to either internal or external customers

Assembly Division should purchase from Producing Division

Cost-based transfer price

If based on incremental cost Producing Division has no contribution

margin

If based on full-absorption cost Assembly Division may buy from external

source because of higher transfer price

May be bad decision because the fixed portion of the transfer price will be incurred regardless

Multinational transfer pricing

Multinational companies may operate in countries with different tax rates, import duties, etc.

Transfer prices should be set to minimize profits in high-tax countries and maximize them in low-tax countries

High transfer price if buyer is in a higher-tax country than the seller

Multinational transfer pricingSeller in high-

tax countryBuyer in low-tax country Combined

Revenue 5,000,000$ 30,000,000$ 35,000,000$ Third-party costs (300,000) (1,400,000) (1,700,000) Transferred goods cost (5,000,000) (5,000,000) Taxable income 4,700,000$ 23,600,000$ 28,300,000$ Tax rate 75% 30%Tax liability 3,525,000$ 7,080,000$ 10,605,000$

Revenue 2,000,000$ 30,000,000$ 32,000,000$ Third-party costs (300,000) (1,400,000) (1,700,000) Transferred goods cost (2,000,000) (2,000,000) Taxable income 1,700,000$ 26,600,000$ 28,300,000$ Tax rate 75% 30%Tax liability 1,275,000$ 7,980,000$ 9,255,000$