Chapter 17 Transfer Pricing Overview PDF

# Chapter 17: Transfer Pricing - Overview ## 17.1 Objectives of Transfer Pricing - A transfer price is the price charged internally by one component of an organization, such as a department, division to another component of the same organization for a product or service. - This chapter will refer...

# Chapter 17: Transfer Pricing - Overview ## 17.1 Objectives of Transfer Pricing - A transfer price is the price charged internally by one component of an organization, such as a department, division to another component of the same organization for a product or service. - This chapter will refer to these components as divisions; however, the same analysis applies to all intercompany transfers. - Consider a large telecommunications provider operating several divisions including a wholesale supplier, a cable television network, and an internet service provider. - Through it's wholesale division the organization sells significant amounts of network bandwidth to external internet providers, which in turn provide internet access and other services to their customers. - The wholesale division also sells its bandwidth internally to the organization's own internet division. - Alternatively, a manufacturer may use transfer pricing to move its goods from one department to the next as part of the manufacturing process. - Consider a boat manufacturer where the divisions include Engines, Hulls, Assembly, and Sales. - The Engines and Hulls divisions manufacture these components, and then "sell" the parts to the Assembly division, where they are put together into a final product. - The finished boats are then sold to the Sales division, and then to external customers. ## 17.1.1 Interpersonal Conflicts with Transfer Pricing - Assuming that the divisions are operating as profit centres, where they are focused on and evaluated based on profit maximization, the goal of each division will be to maximize its individual profit. - This means that the selling division in an internal sale will want to sell products at the highest transfer price possible and the buying division will want to receive products at the lowest transfer price possible. - Managers have an inherent bias to put their needs ahead of the organization, so it is important that the transfer-pricing policy is considered in the context of how managers are evaluated. - In some cases, this can lead to behavior that results in the organization's total profit being reduced. - This is often referred to as a lack of goal congruence. ## 17.1.2 Relevant Factors - When determining transfer prices, it is important to consider the relevant costs to the decision and particularly to the organization. - By considering costs to the organization, managers should be more likely to put the organization's interests ahead of their own. - Unless otherwise stated, when asked to discuss transfer-pricing strategies, assume the user is requesting an analysis of short-term factors. - In the long term, some costs (such as a factory or salaried employees) can be eliminated, however, this would be a permanent decision and would be undertaken at a more overall strategic level. - In the short term, fixed costs are irrelevant because they cannot be easily eliminated. - Similarly, sunk costs are not relevant in the decision-making process because they have already occurred and there is no ability to avoid them. ## 17.2 Transfer-Pricing Methods - The common transfer-pricing approaches discussed are: - Cost-based transfer pricing - Market-based transfer pricing - Negotiated transfer pricing - Other, including administered transfer pricing, profit splitting, and dual-rate transfer pricing - This chapter does not address transfer pricing for income tax purposes. ## 17.2.1 Minimum Transfer Price - Although there is no concrete rule for transfer pricing that ensures optimal decision-making for the organization, the following guideline may be useful in establishing a minimum transfer price: - Minimum transfer price = Variable costs up to the point of transfer + Opportunity cost to the selling division ## 17.2.2 Cost-Based Transfer Pricing - Under cost-based transfer pricing, transfer prices are based on a formula applied to some measure of the product's cost. - Full-cost bases measure the full absorption cost of the product being transferred plus a markup. - Variable costs measure the variable cost of the product being transferred plus a markup. - Note that a markup may or may not be applied to costs when determining the transfer price, depending on whether it is required by the seller. - Cost-based transfer prices have the advantage of being simple and readily available. They are the most useful when market prices are unavailable, inappropriate, or too costly to obtain. - This could be the case when the product is specialized or unique and not readily available from external sources. - Cost-based transfer prices can also be appropriate when the selling unit operates as a cost centre. - A major drawback of cost-based transfer pricing is that it can lead to decisions by either the seller or the buyer that are not in the best interest of the organization as a whole. - These are referred to as suboptimal decisions. ## 17.2.3 Market-Based Transfer Pricing - Under market-based transfer pricing, transfer prices are based on external market conditions such as the prices of external suppliers or the prices charged to external customers. - The use of market prices will generally lead to optimal decision-making when three conditions are satisfied: - The immediate market must be perfectly competitive and information readily available. - Interdependencies between the departments must be minimal. - There must be no additional costs or benefits to the organization as a whole in using the external market instead of transacting internally. ## 17.2.4 Negotiated Transfer Pricing - Under negotiated transfer pricing, the seller - and buyer work - together to - come up with an internal - transfer price for the - product or service. - Because the two must work together, the - negotiation process - can be time-consuming. - As discussed at the - beginning of this - chapter, and ignoring - relevant qualitative effects, the goal - of both parties - will be to benefit - themselves. ## 17.2.5 Other Transfer Pricing Methods - The transfer pricing methods - discussed above are - the most common - methods of - setting transfer prices. ## 17.3 International Transfer Pricing - The approaches to transfer pricing discussed above are applicable to divisions operating in the same country. - Management accountants call this class of transfer prices domestic transfer prices. - However, organizations often have divisions or segments that cross international borders. - International transfer prices arise when goods and services are transferred between different tax jurisdictions. - For example, an organization may have a North American business segment and an Asian business segment. - Because transactions involving international transfer prices are between related parties, they are sometimes referred to as "controlled transactions." - The organization's transfer-pricing objectives change when the transfers occur internationally. ## Summary: Transfer Pricing Problem - Plastics Chemical Company Inc. (PCCI) is a small chemical business whose primary product is polyvinyl chloride, commonly referred to as PVC. - PCCI is a vertically integrated organization that produces several PVC-based products. - It has three divisions: - Petroleum: extracts the petroleum. - PVC compound: turns the petroleum into PVC. - Siding: uses the PVC to manufacture vinyl siding.