MIDTERMS

Transfer pricing is used to improve control and evaluation in organizations by setting up an “open market” system for business units
within the organization to negotiate on goods and services that are transferred within the organization. This lesson will discuss the
transfer pricing process and how prices are set between business units.
Upon completion of this lesson, candidates should be able to:
• Define transfer pricing and identify the objectives of transfer pricing (1.C.2.h).
• Identify the methods for determining transfer prices and list and explain the advantages and disadvantages of each method
(1.C.2.i).
• Identify and calculate transfer prices using variable cost, full cost, market price, negotiated price, and dual-rate pricing
(1.C.2.j).
• Explain how transfer pricing is affected by business issues such as the presence of outside suppliers and the opportunity costs
associated with capacity usage (1.C.2.k).
• Describe how special issues such as tariffs, exchange rates, taxes, currency restrictions, expropriation risk, and the availability
of materials and skills affect performance evaluation in multinational companies (1.C.2.l).
Study Guide

I. Need for Transfer Pricing

A. Remember in our last lesson that business units can be set up as cost centers, revenue centers, profit centers, and
investment centers. Cost centers and revenue centers often struggle with incentives that aren't aligned well with the
overall organization.
1. Cost centers are incentivized to reduce costs, but that incentive can motivate a cost center to minimize or
delay support and services to other business units and damage overall company profitability.
2. Revenue centers are incentivized to increase revenue without respect to costs. This kind of motivation can
lead revenue centers to be very inefficient with resources of other business units, also leading to reduced
overall profits in the company.
B. As organizations increase in size and complexity, competitive internal pricing can be used to motivate performance
and discipline processes in cost centers and revenue centers. Transfer pricing systems align cost centers and
revenue centers with the organization's profit focus. Note, however, that a transfer price is essentially a budget
transfer between business units that by itself doesn't actually change overall profits in the organization.
C. Since the transfer price represents a revenue to the supplying business unit and a cost to the receiving business unit,
managers of both business units will be focused on the maximizing the “profit” in this internal transaction. If the price
is set correctly, the receiving business unit will expect quality and timeliness in the transaction, and the supply unit will
be incentivized to provide the quality and timeliness. Setting the right transfer price is key for the transaction to take
place.
II. Variable Cost Transfer Pricing
A. Let's return to the International Manufacturing Corporation (IMC) example from the previous lesson. The organization
chart for IMC is provided below.

1. The U.S. Region in the Acme Computer Company has been purchasing monitor screens from an outside vendor that is
assembled into the computers being manufactured and sold in the U.S. for $900 per computer. The U.S. Region business unit
pays $110 per screen. Combined with $340 in other variable costs, this business unit has a $450 contribution margin on each
computer sold on a monthly sales volume of 5,000 computers.
2. The China Operations business unit is selling monitor screens in its market at a $140 equivalent price (actual China
Operations revenue is in Chinese yuan). The equivalent variable cost to manufacture each screen is $90, resulting in a $50
contribution margin. The China Operations monthly sales volume is 20,000 screens.
3. Data on both business units are provided below, including monthly fixed costs. Without any transfers taking place between the
two business units, monthly performance combines to equal $950,000 in total profit for IMC

B. IMC, through its U.S. Region, is paying $110 to purchase computer monitor screens. But IMC can manufacture
monitor screens at a variable cost of $90 in its China Operations. It makes sense for IMC if China Operations build
and transfer screens to the U.S. Region, but at what transfer price? It turns out that for the overall IMC organization it
doesn't matter what transfer price is used in the internal transaction.
C. Let's assume that the transfer takes place using China Operations’ variable cost to produce a monitor screen. China
Operations has the capacity to build the additional 5,000 screens needed in the U.S., and the cost to build these
additional screens will be just the variable cost of $90. A transfer using the variable cost would result in the following
combined monthly performance report.
 D. The bottom highlighted line reports the increase or decrease in operating profit compared to the original combined
monthly performance report with no transfer taking place between the business units. China Operations has no
change in monthly profit, but the U.S. Region's profit will increase by $100,000, because it will save $20 per monitor
screen ($110 – $90) by purchasing the screens internally ($20 × 5,000 computers = $100,000).
E. Setting the transfer price based on variable costs is often profitable for the receiving business unit, but the supplying
business unit has no profit incentive to agree to the transfer at the variable cost price (except that it provides the
means to give more employment for the business unit's employees).

III. Full Cost Transfer Pricing

A. Alternatively, organizations can set transfer prices based on full costs. This approach is often used by organizations
since it represents a cost that is typically reported in accounting systems. A full cost transfer price provides a
contribution margin to the supplying business unit to help cover its own costs, but it results in a higher price that the
receiving business unit may not want to pay.
B. Returning to our example, let's assume that the transfer price is based on China Operation's full cost per unit. This
business unit's total fixed costs are $600,000 (and are not expected to increase based on the additional 5,000
screens for the U.S. Region). The fixed cost per unit is computed as follows:
$600,000 ÷ (20,000 screens + 5,000 screens) = $24 per screen

C. A transfer using the full cost of $114 per monitor screen ($90 + $24) will provide the following combined monthly
performance report

Note that China Operations has an increase in monthly profit of $120,000 but the U.S. Region's profit will decrease by
$20,000 based on paying $4 more per monitor screen ($110 – $114).
D. Most importantly, note that IMC's overall profit will increase by the same $100,000 using either the variable cost or
the full cost. The company's overall profit is unaffected by the transfer price. The only thing that affects overall profit
for IMC is whether or not the transfer takes place.

IV. Managing Transfer Pricing

A. There are two issues in transfer pricing that need to be clearly managed and separately evaluated. First, does the
organization want the transfer to take place between the two business units? In other words, will a transfer increase
or decrease overall profits for the organization?
1. If there isn't an external supplier (vendor), then without an outside alternative the only option available is a
transfer between the two business units.
2. If the option to use an external supplier does exist, then the organization must determine if it is cheaper to
buy externally or cheaper to internally produce and transfer the product or service. The method to determine
the right solution is as follows:
I. Is external market price > variable cost + opportunity cost + incremental fixed cost?
II. If market price is higher, then the organization will be benefited by an internal transfer. (Opportunity
costs and incremental fixed costs will be discussed later.)
B. Assuming the organization wants the transfer to take place, the second issue to manage is setting the transfer price
such that both business units will be incentivized to participate in the transfer.
1. The supplying business unit needs to cover its variable costs plus any opportunity costs of making the
transfer (i.e., lost profits in the open market) as well as any incremental fixed costs that may be required to
provide the product to the receiving business unit. If the supplying business unit can make a profit on these
costs, it will have incentive to do the transfer.
2. The receiving business unit does not want to pay more than the price available in the external market. If
there are any transaction savings by doing an internal transfer (for example, packaging or shipping that can
be avoided), the receiving business unit may be willing to pay a higher price so long as the difference is
offset by transaction savings. The key to incentivizing the receiving business unit is a transfer price that
results in a net cost savings.
 V. Market-Based Transfer Pricing and Opportunity Costs
A. In determining the transfer price, the supplying business unit sets the floor (minimum) on that price and the receiving
business unit sets the ceiling (maximum). When using costs to set price, the receiving business unit wants to pay the
variable cost, and the supplying business unit wants to charge the full cost. How do these two business units resolve
on the transfer price? If there is an outside market for the product or service, then most organizations will set the
transfer price on the market price that the receiving business unit would normally pay.
B. The receiving unit's market price can create a competitive pressure (and opportunity) for the supplying business unit
to reduce costs while improving the quality and timeliness of the product or service in order to compete effectively
with the outside market for the transaction. This incentive aligns well with the organization's overall goals.
C. What about the outside market for the supplying business unit? If the supplying business unit is selling to an outside
market, that situation is relevant only if the supplying business unit is running out of production capacity.
1. If the supplying business unit has to give up any outside business in order to transfer product to the
receiving business unit, then the lost contribution margin on that outside business is an opportunity cost that
needs to be factored into the transfer price.
2. In this case, the supplying business unit will set the minimal transfer price as follows:
(Total variable costs to supply units + total contribution margin lost) ÷ total units supplied
3. And if there is an incremental fixed cost for the supplying business unit to produce and transfer product to
the receiving business unit (e.g., special equipment or training), that fixed cost also needs to be factored into
the minimal transfer price, as follows:
(Total variable costs + contribution margin lost + incremental fixed costs) ÷ total units supplied
D. With the IMC example, let's assume that China Operations’ production capacity limit is 24,000 monitor screens each
month. If this is an all-or-nothing transfer situation, then China Operations must give up 1,000 units of the 20,000
units of outside sales in order to supply the U.S. Region with 5,000 screens. In addition, assume that China
Operations must pay $10,000 each month for the shipping container to get the monitor screens to the U.S. Region.
1. Remember that China Operations normally makes the equivalent of $50 on each monitor screen it sells into
its market. Hence, it has an opportunity cost of $50,000 ($50 × 1,000 screens) in lost contribution margin by
making the internal transfer.
2. Combined with the $10,000 of incremental fixed costs, the minimal transfer price that China Operations will
demand is:
$90 variable production cost per screen + ($50,000 + 10,000) ÷ 5,000 screens = $102
3. The U.S. Region is currently paying $110 to an external vendor in its market to obtain monitor screens.
Hence, these two business units should be incentivized to set the price between $102 and $110 and make
the transfer. Assuming the transfer price is set at $106 per screen, the following combined monthly
performance report would result:

Monthly Performance – Transfer at Negotiated Cost (Capacity limited to 24,000 monitor screens per month) (Incremental
$10,000 fixed cost for transfer)

4. The overall improvement in IMC profits ($40,000) is due to the

difference in the total cost to provide monitor screens versus
the cost to purchase from an external vendor, multiplied by the
number of screens.
5. It is important to understand that it doesn't matter to the IMC
($110 − $102) × 5,000 screens = $40,000 total costs saved
organization what transfer price is used between these two
business units. Whatever transfer price is established will
effectively divide the $40,000 in cost savings between the two
business units. Hence, it's a negotiating process.

E. It is important to understand that the first issue in managing the transfer price process is to determine if the transfer
takes place at all. In other words, will it improve overall profits for the organization to internally produce and transfer
the product versus buy the product from an outside vendor? This is a straightforward make-or-buy decision.
1. To demonstrate, let's assume that production capacity at China Operations is actually 23,000 monitor
screens per month, which means it will give up 2,000 units of outside sales to make the internal transfer.
2. These lost sales have an opportunity cost of $100,000 (= $50 contribution margin × 2,000 units). As a result,
the cost to produce and transfer the 5,000 monitor screens (i.e., the minimum transfer price) is:
$90 variable production cost per screen + ($100,000 + 10,000) ÷ 5,000 screens = $112
3. This cost is higher than the $110 outside market price (i.e., the maximum transfer price), which means IMC
will lose $10,000 if the internal transfer takes place.
($110 − $112) × 5,000 screens = $10,000 total cost increase
Clearly, the transfer should not take place.
VI. Negotiated Pricing and Dual-Rate Pricing
A. The intent of the transfer price computations we've been doing are to (1) determine if a transfer should in fact take
place, and (2) identify the price range (floor and ceiling) within which the supplying (selling) business unit and
receiving (buying) business unit will negotiate a transfer price. The decision tree below can be used to guide and
summarize this process
 B. A key aspect of successful management using transfer pricing is to create an
“open market” within the organization wherein business units compete and
negotiate with each other to set prices and make transfers. This approach creates
positive competitive pressure to keep costs down and quality up on goods and
services being delivered within the organization.
C. The challenge with an “open market” approach is that managers of business
units don't always make the most optimal decision for the organization. For
example, due to poor accounting information or misaligned incentives, managers
of business units may choose to not transfer when it's actually optimal for the
overall organization to have a transfer take place.
D. When managers of business units are making suboptimal decisions to engage in
a transfer or not, it is tempting for the executive management team to step in and
force the optimal decision. Generally, this is not advisable; otherwise, the benefits
of important management objectives related to delegation, decision speed, and
management training are lost.
E. A compromise approach to encourage managers of business units to make
optimal decisions is to establish an accounting system that allows dual pricing.
1. For example, the accounting system could be designed to allow the supplying business to use a full cost-
based price to recognize revenue into its profit performance report while allowing the receiving business unit
to use a variable cost-based price to recognize costs into its profit performance report.
2. The difference between the two prices will have to be carried in the organization's overall accounting system
and reconciled at the end of the reporting period.
VII. Managing International Issues
A. This lesson has emphasized the principle that the only transfer pricing factor affecting actual company profits at IMC
is whether a transfer actually takes place between business units. The transfer price used in the transaction simply
determines how the cost savings is split between each business unit. The transfer price itself doesn't affect overall
profits for the organization.
B. However, this principle is only true when the organization conducts business within a single economic geography.
When the organization's business units are spread across different economic zones, then issues such as tax rates,
tariffs, exchange rates, and currency restrictions enter into the management decision on whether to conduct an
internal transfer and what transfer price to use.
C. The transfer pricing example used in this lesson (IMC) is based on internal transactions between a business unit in
China and a business unit in the U.S. Because transactions between these two business units cross international
boundaries, a number of issues can complicate how IMC manages its transfer pricing processes.
1. For example, if the income tax rate in the U.S. is comparatively higher than in China, IMC may encourage
transfer prices that result in most of the cost savings being split toward China Operations. In the choice
between variable cost and full cost pricing, IMC will reduce its tax expense if full cost pricing is used to
locate most of the cost savings in China.
2. As another example, trade tariffs are another form of a tax. If the U.S. places a high tariff rate on the value of
computer technology goods coming into its country, then IMC is likely to encourage lower transfer prices on
the monitor screens that China Operations ships to the U.S. Region. Hence, in the choice between variable
costs or full costs, IMC will reduce the cost of tariffs by using variable costs to set transfer prices.
3. A final example: In order to manage the economic impact of large outflows of cash or assets from its
country, governments can use currency restriction laws to limit how much cash a company can transfer out
of the country's economy over a certain period of time. An organization can use transfer pricing to manage
this risk (sometimes called “expropriation risk” or “policy risk”) of having its cash retained in one country
when it's needed in another country. If IMC is concerned that the U.S. is going to restrict the transfer of
currency out of its country, it may encourage the use of full cost-based transfer pricing to increase the
amount of cash that the U.S. Region pays China Operations for monitor screens.
D. As a final note on international issues involved in transfer pricing policy, most country governments pay close
attention to companies that use internal transfer prices primarily to reduce income tax expense, avoid paying tariffs,
or work around currency restriction laws. To that end, there is significant government regulation involved in the
process of setting transfer prices for international organizations like IMC.
Summary
• Transfer prices are simply budget transfers between different business units in an organization.
• However, transfer prices can be a powerful management mechanism to encourage better performance by establishing
“competitive markets” between business units within the organization.
• If a business unit can supply a product or service to another business unit at a cheaper price and/or at a higher quality than an
external vendor, a transfer price can be used to share (i.e., split) the cost savings or value created by the internal exchange.
• Transfer prices are based on a combination of internal costs and external market prices.
• Internal costs include the variable costs, any incremental fixed costs, and the opportunity cost of lost sales for the supplying
business unit (i.e., the seller).
• These three potential internal costs for the seller serve as the floor price for the internal transfer.
• If the receiving business unit (i.e., the buyer) is able to obtain the product or service from an external vendor, then the market
price that the buyer would have to pay the external vendor serves as the ceiling price for the internal transfer.