TRANSFER PRICING

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Class Announcements
Service Learning Assignment:
Schedule a meeting with Danika Leblanc
(x2010quu@stfx.ca) prior to contacting your organization
See Service Learning Project on-line
See M Oxner if not assigned to a project
Next class In lieu of class (both sections) Leadership
Forum at 2:15pm in SCHW 110. Speaker Richard
Peddie, Former CEO Maple Leaf Sports and
Entertainment
Assignment #2 due February 10, available on-line
Midterm February 19
th
(Wednesday)- discussed at end of
class
Office hours on Wednesday 9:00am-12:00noon
Business Banquet - April 2nd 5:45-8pm, Catering -
Gabrieau's Bistro; Keynote Speaker - Annette Verschuren,
Past President of Home Depot for Canada and Asia


2012 Pearson Prentice Hall. All rights reserved.
Class Objectives
1. Understanding transfer pricing as an internal
pricing mechanism
2. Understanding transfer pricing as a means
for evaluation
3. Consider the implications of transfer pricing
on behaviour


Transfer Pricing
When evaluations are based on profit, etc. we
need to establish price for internal transfers
Transfer price is the price one subunit
(department or division) charges for a product or
service supplied to another subunit of the same
organization. p. 780
Transfer prices can have a dramatic effect on the
reported profitability of a division but not on
overall profit
In a well designed transfer pricing system a
manager focuses on optimizing subunit
performance and in doing so optimizes the
performance of the whole company.
2 0 1 2 P e a r s o n P r e n t i c e
H a l l . A i l l r i g h t s r e s e r v e d . i
Transfer Pricing: Internal Price
Management control systems use transfer prices
to coordinate the actions of subunits and to
evaluate their performance.
The transfer price creates revenues for the
selling subunit and purchase costs for the buying
subunit affecting each subunits operating
income.
When segments sell to one another, a benefit to
one segment may have a negative impact on
another segment (internal transfer)
Transfer price becomes a cost to the buying
division and revenue to the selling division.


2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: Purposes
1) Promote goal congruence
2) To guide managers to decide whether to buy
internally or externally
a good transfer price is one that induces division
managers to do whatever is in the best interest of the
entire company otherwise sub optimization (i.e. each
division manager makes a decision to maximizes the
companys profit).
3) To evaluate segment performance
4) To minimize taxes, duties & tariffs for
multinationals
5) Preserve autonomy
Transfer Pricing: Rule
Transfer Price = Incremental Cost+ Opportunity
Cost
Incremental cost is additional cost of producing ad
transferring a product or service
Opportunity cost is the maximum contribution
margin foregone by selling if product or service is
transferred internally.
Transfer price depends on capacity
Excess capacity TP=Incremental Cost
No excess capacity TP= Incremental Cost+ Opp
Cost
Transfer Pricing: Methods
Difficulty in implementing this rule yielded three
approaches to determining transfer price.
1. Market-based transfer prices
2. Cost-based transfer prices
3. Hybrid transfer prices
i. Prorated transfer prices
ii. Dual transfer prices
iii. Negotiated transfer prices
2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: 1.Market-Based
Top management chooses to use the price of
similar product or service that is publicly
available.
Sources of prices include trade associations,
competitors, and so on.
Lead to optimal decision-making when three
conditions are satisfied:
1. The market for the intermediate product is perfectly
competitive.
2. Interdependencies of subunits are minimal.
3. There are no additional costs or benefits to the
company as a whole from buying or selling in the
external market instead of transacting internally.

2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: 1.Market-Based
A perfectly competitive market exists when there is
a homogeneous product with buying prices equal
to selling prices and no individual buyer or seller
can affect those prices by their own actions.
Allows a firm to achieve goal congruence,
motivating management effort, subunit
performance evaluations, and subunit autonomy.
Perhaps should not be used if the market is
currently in a state of distress pricing.
Because not based on costs, motivates each
division manager to exert management effort to
maximize his or her own divisions operating
income (cost management)
2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: 1.Market-Based
Advantages:
i) avoids routinely bogging down negotiations
ii) if no idle capacity, market price is the perfect choice
iii) external segmented reporting using market price
Disadvantages:
i) market prices are not always known
ii) may reduce possibility of generating benefits
through cooperation
Transfer Pricing: 2.Cost-Based
Top management chooses a transfer price based
on the costs of producing the intermediate
product. Examples include:
Variable production costs
Variable and fixed production costs
Full costs (including life-cycle costs)/absorption costing
One of the above, plus some markup
Useful when market prices are unavailable,
inappropriate, or too costly to obtain
2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: 2.Cost-Based
Advantages:
i) commonly used in practice
ii) easily understood and convenient to use
Disadvantages:
i) distinction between fixed and variable costs are
blurred (absorption cost leads to dysfunctional
behavior)
ii) since inefficiencies are passed on, lacks
incentive to control expenditures/assets
(standards avoid this)
Transfer Pricing: 3.Hybrid
Takes into account both cost and market
information
Types of hybrid transfer prices:
Prorating the difference between maximum and
minimum transfer prices
Dual pricing
Negotiated pricing (most common)
2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: 3.Hybrid
Dual-pricing transfer prices
charge the buying division for the cost of the
transferred product (however the cost might be
determined) and credits the selling division with
the cost plus some profit allowance.
using two separate transfer-pricing methods to
price each transfer from one subunit to another.
not used much in practice
example: selling division receives full cost
pricing, and the buying division pays market
pricing.
2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: 3.Hybrid
Negotiated transfer prices:
Occasionally, subunits of a firm are free to negotiate
the transfer price between themselves and then to
decide whether to buy and sell internally or deal with
external parties.
May or may not bear any resemblance to cost or
market data.
Often used when market prices are volatile.
Represent the outcome of a bargaining process
between the selling and buying subunits.
Promotes autonomy

2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: 3.Hybrid
Disadvantages of Negotiated Transfer Price:
i) time consuming
ii) may lead to bad blood between mangers of different
subunit; Given the disputes that often accompany the
negotiation process, most companies rely on some other
means of setting transfer prices.
iii) If managers are pitted against each other rather than
against their past performance or reasonable benchmarks,
a non-cooperative atmosphere is almost guaranteed.
Note: The principles of decentralization suggest that
companies should grant managers autonomy to set
transfer prices and to decide whether to sell internally
or externally, even is this may occasionally result in
suboptimal decisions.
Transfer Pricing: Method Comparison
2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing: International
Transfer Pricing Objectives
Domestic
Greater divisional autonomy
Greater motivation for managers
Better performance evaluation
Better goal congruence
International
Less taxes, duties, and tariffs
Less foreign exchange risks
Better competitive position
Better governmental relations
Friday, Wednesday February19th(in-class)
Worth: 30%
Coverage: Chpts. 6, 7, 8 , 22 (p. 780-791), 23 (p. 808-
814)
Format:
Short answer questions with multiple parts
No multiple choice, journal entries, ethics
Answer for only THREE of the four questions; each question is
worth 25 points.
Preparation:
Problems On-line
Lecture Notes On-line
Additional Office Hours:
Tuesday 18
th
11:00am 1:00pm (normally none)
Wednesday 19
th
9:00am 2:00pm (normally 11:00am 2:00pm)


Midterm