Transfer Pricing

Appendix 12A

Key Concepts/Definitions

A transfer price is the price

charged when one segment of
a company provides goods or
services to another segment of
the company.

The fundamental objective in

setting transfer prices is to
motivate managers to act in the
best interests of the overall
company.

Three Primary Approaches

There are three primary
approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.

Negotiated Transfer Prices

A negotiated transfer price results from discussions
between the selling and buying divisions.
Advantages of negotiated transfer prices:
1.

They preserve the autonomy of the

divisions, which is consistent with
the spirit of decentralization.

2.

The managers negotiating the

transfer price are likely to have much
better information about the potential
costs and benefits of the transfer
than others in the company.

Range of Acceptable
Transfer Prices
Upper limit is
determined by the
buying division.

Lower limit is
determined by the
selling division.

Grocery Storehouse
Assume the information as shown with respect
to West Coast Plantations and Grocery Mart
(both companies are owned by Grocery
Storehouse).

Grocery Storehouse
West Coast Plantation can provide supply of
oranges to Grocery Mart (a unit of Grocery
Storehouse)

West Coast Plantation selling division

Grocery Mart buying division

Grocery Storehouse An
Example
The selling divisions (West Coast Plantations) lowest acceptable transfer
price is calculated as:
Variable cost
Total contribution margin on lost sales
Transfer Price
+
per unit
Number of units transferred

Lets calculate the lowest and highest acceptable

transfer prices under three scenarios.
The buying divisions (Grocery Mart) highest acceptable transfer price is
calculated as:

Transfer Price Cost of buying from outside supplier

Grocery Storehouse An
Example
If West Coast Plantations has sufficient idle capacity (3,000 crates) to
satisfy Grocery Marts demands (1,000 crates), without sacrificing
sales to other customers, then the lowest and highest possible
transfer prices are computed as follows:
Selling divisions lowest possible transfer price:

Buying divisions highest possible transfer price:

Therefore, the range of acceptable

transfer prices is $10 $20.

Grocery Storehouse An
Example
If West Coast Plantations has no idle capacity (0 crates) and must
sacrifice other customer orders (1,000 crates) to meet Grocery Marts
demands (1,000 crates), then the lowest and highest possible
transfer prices are computed as follows:
Selling divisions lowest possible transfer price:

Buying divisions highest possible transfer price:

Therefore, there is no range of

acceptable transfer prices.

Grocery Storehouse An
Example
If West Coast Plantations has some idle capacity (750 crates) and
must sacrifice other customer orders (250 crates) to meet Grocery
Marts demands (1,000 crates), then the lowest and highest possible
transfer prices are computed as follows:
Selling divisions lowest possible transfer price:

Buying divisions highest possible transfer price:

Therefore, the range of acceptable

transfer prices is $13.75 $20.00.

Transfers at the Cost to the

Selling Division
Many companies set transfer prices at either
the variable cost or full (absorption) cost
incurred by the selling division.
Drawbacks of this approach include:
1. Using full cost as a transfer price
can lead to suboptimization.
2. The selling division will never
show a profit on any internal
transfer.
3. Cost-based transfer prices do not
provide incentives to control
costs.

Transfers at Market Price

A market price (i.e., the price charged for an
item on the open market) is often regarded as
the best approach to the transfer pricing
problem.
1. A market price approach works
best when the product or service
is sold in its present form to
outside customers and the
selling division has no idle
capacity.
2. A market price approach does
not work well when the selling
division has idle capacity.

Divisional Autonomy and

Suboptimization

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 if this may
occasionally result in
suboptimal decisions.
This way top management
allows subordinates to
control their own destiny.

Ex 12A-1 Case A
DIVISION X

Capacity in units

200,000

Number of units being sold to outside customers

200,000

Selling price per unit to outside customers

$90

Fixed cost per unit (based on capacity)

$13

DIVISION Y
Purchase price per unit now being paid to an outside
supplier

$86

Number of units needed for production

40,000

Assume that there is a $3 per unit in variable selling costs

that can be avoided on intercompany sales. What is the
range of transfer prices?

Ex 12A-1 Case B
DIVISION X

Capacity in units

200,000

Number of units being sold to outside customers

160,000

Selling price per unit to outside customers

$75

Fixed cost per unit (based on capacity)

$8

DIVISION Y
Purchase price per unit now being paid to an outside
supplier

$74

Number of units needed for production

40,000

Assume that there is will be no savings in variable selling

costs on intercompany sales. What is the range of transfer
prices?

Ex 12A-2
Sako Companys Audio Division produces a speaker that is used by
manufacturers of various audio products. Sales and cost data on the
speaker follow:
Selling price per unit on the intermediate market

$60

Variable cost per unit

$42

Fixed costs per unit

$8

Capacity in units

25,000

Sako Companyhas a Hi-Fi Division that could use this speaker in one
of its products. The Hi Fi Division will need 5000 speakers per year. It
has received a quote of $57 per speaker form another manufacturer.
Sake Company evaluates division managers on the basis of divisional
profits.

Ex 12A-3
Division A manufactues electronic circuit boards. The boards can be
sold either to division B of the same company or to outside customers.
Last year, the following activity occurred in Division A.
Selling price per circuit board

$125

Variable cost per circuit board

$90

Number of circuit boards:

Produced during the year:

20,000

Sold to outside customers

16,000

Sold to Division B

4,000

Sales to Division B were at the same price as sales to outside

customers. The circuit boards purchased by Division B were used in
an electronic instrument manufactured by that division. Division B
incurred $100 in additional variable cost per instrument and then sold
the instruments for $300 each.

Ex 12A-3
Selling price per circuit board

$125

Variable cost per circuit board

$90

Number of circuit boards:

Produced during the year:

20,000

Sold to outside customers

16,000

Sold to Division B

4,000

1) Prepare an income statement for Division A, Division B and the

company as a whole.
2) Assume that division As capacity is 20,000 circuit boards. Next
year, Division B wants to purchase 5,000 circuit boards from
Division A rather than 4,000. (Circuit boards of this type is not
available from outside sources) Should the company sell to
Division B or sell them to outside customers?

END OF COVERAGE OF QUIZ 4

Financial Statement Analysis

Ratio Analysis The Common

Stockholder
The ratios that
are of the most
interest to
stockholders
include those ratios
that focus on net
income, dividends,
and stockholders
equities.

Earnings Per Share

Earnings per Share =

Net Income Preferred Dividends

Average Number of Common
Shares Outstanding

Whenever a ratio divides an income statement

balance by a balance sheet balance, the average
for the year is used in the denominator.
Earnings form the basis for dividend payments
and future increases in the value of shares of
stock.

Earnings Per Share

Earnings per Share =

Net Income Preferred Dividends

Average Number of Common
Shares Outstanding

Earnings per Share =

$53,690 $0
($17,000 + $27,400)/2

= $2.42

This measure indicates how much

income was earned for each share of
common stock outstanding.

Price-Earnings Ratio
Price-Earnings
Ratio
Price-Earnings
Ratio

Market Price Per Share

Earnings Per Share
$20.00
$2.42

= 8.26 times

A higher price-earnings ratio means that

investors are willing to pay a premium
for a companys stock because of
optimistic future growth prospects.

Dividend Payout Ratio

Dividend
Payout Ratio

Dividend
Payout Ratio

Dividends Per Share

Earnings Per Share

$2.00
$2.42

= 82.6%

This ratio gauges the portion of current

earnings being paid out in dividends. Investors
seeking dividends (market price growth) would
like this ratio to be large (small).

Dividend Yield Ratio

Dividend
Yield Ratio
Dividend
Yield Ratio

Dividends Per Share

Market Price Per Share
$2.00
$20.00

= 10.00%

This ratio identifies the return, in terms

of cash dividends, on the current
market price of the stock.

Return on Total Assets

Return on
=
Total Assets

Net Income + [Interest Expense (1 Tax Rate)]

Average Total Assets

Return on
=
Total Assets

$53,690 + [$7,300 (1 .30)]

= 18.19%
($300,000 + $346,390) 2
Adding interest expense back to net income
enables the return on assets to be compared
for companies with different amounts of debt
or over time for a single company that has
changed its mix of debt and equity.

Return on Common
Stockholders Equity
Return on Common = Net Income Preferred Dividends
Stockholders Equity
Average Stockholders Equity
Return on Common =
$53,690 $0
= 25.91%
Stockholders Equity
($180,000 + $234,390) 2
This measure indicates how well the
company used the owners
investments to earn income.

Financial Leverage
Financial leverage results from the difference between the rate of
return the company earns on investments in its own assets and the
rate of return that the company must pay its creditors.

Quick Check

Which of the following statements is true?

a. Negative financial leverage is when the
fixed return to a companys creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a companys creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years financial data in
percentage form in terms of a base year.

Quick Check

Which of the following statements is true?

a. Negative financial leverage is when the
fixed return to a companys creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a companys creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years financial data in
percentage form in terms of a base year.

Book Value Per Share

Book Value
per Share
Book Value
per Share

Common Stockholders Equity

Number of Common Shares Outstanding

$234,390
27,400

= $ 8.55

This ratio measures the amount that would be

distributed to holders of each share of common
stock if all assets were sold at their balance sheet
carrying amounts after all creditors were paid off.

Book Value Per Share

Book Value
per Share
Book Value
per Share

Common Stockholders Equity

Number of Common Shares Outstanding

$234,390
27,400

= $ 8.55

Notice that the book value per share of $8.55 does

not equal the market value per share of $20. This
is because the market price reflects expectations
about future earnings and dividends, whereas the
book value per share is based on historical cost.

Learning Objective 3
Compute and interpret
financial ratios that would
be useful to a short-term
creditor.

Ratio Analysis The Short

Term Creditor
Short-term
creditors, such as
suppliers, want to
be paid on time.
Therefore, they
focus on the
companys cash
flows and working
capital.

Working Capital
The excess of current assets
over current liabilities is known
as working capital.
Working capital is not
free. It must be
financed with longterm debt and equity.

Working Capital

Current Ratio
Current
Ratio

Current Assets
Current Liabilities

The current ratio measures a

companys short-term debt
paying ability.
A declining ratio may be a
sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.

Current Ratio
Current
Ratio

Current Assets
Current Liabilities

Current
Ratio

$65,000
$42,000

1.55

Acid-Test (Quick) Ratio

Acid-Test
=
Ratio
Acid-Test
=
Ratio

Quick Assets
Current Liabilities
$50,000
$42,000

= 1.19

Quick assets include Cash,

Marketable Securities, Accounts Receivable, and
current Notes Receivable.
This ratio measures a companys ability to meet
obligations without having to liquidate inventory.

Accounts Receivable Turnover

Accounts
Receivable
Turnover

Sales on Account
Average Accounts Receivable

Accounts
$494,000
Receivable =
= 26.7 times
($17,000 + $20,000) 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.

Average Collection Period

Average
Collection =
Period
Average
Collection =
Period

365 Days
Accounts Receivable Turnover
365 Days
26.7 Times

This ratio measures, on average,

how many days it takes to collect
an account receivable.

= 13.67 days

Inventory Turnover
Inventory
Turnover

Cost of Goods Sold

Average Inventory

This ratio measures how many times

a companys inventory has been
sold and replaced during the year.
If a companys inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong types of inventory.

Inventory Turnover
Inventory
Turnover

Inventory
Turnover

Cost of Goods Sold

Average Inventory
$140,000
= 12.73 times
($10,000 + $12,000) 2

Average Sale Period

Average
Sale Period

Average
=
Sale Period

365 Days
Inventory Turnover

365 Days
12.73 Times

This ratio measures how many

days, on average, it takes to sell
the entire inventory.

= 28.67 days

Learning Objective 4
Compute and interpret
financial ratios that would
be useful to a long-term
creditor.

Ratio Analysis The LongTerm

Creditor
Long-term creditors are concerned with a
companys ability to repay its loans over the
long-run.

This is also referred

to as net operating
income.

Times Interest Earned Ratio

Times
Interest =
Earned
Times
Interest =
Earned

Earnings before Interest Expense

and Income Taxes
Interest Expense

$84,000
= 11.51 times
$7,300

This is the most common

measure of a companys ability
to provide protection for its
long-term creditors. A ratio of
less than 1.0 is inadequate.

Debt-to-Equity Ratio
Debtto
Total Liabilities
Equity =
Stockholders Equity
Ratio

This ratio indicates the relative proportions of

debt to equity on a companys balance sheet.

Stockholders like a lot of

debt if the company can
take advantage of positive
financial leverage.

Creditors prefer less debt

and more equity because
equity represents a buffer
of protection.

Debt-to-Equity Ratio
Debtto
Total Liabilities
Equity =
Stockholders Equity
Ratio
Debtto
Equity =
Ratio

$112,000
$234,390

= 0.48

Exercises
Exercise: 16-7, 16-8, 16-9 and 16-10.