Advanced Performance Management (APM)

Transfer pricing
& Divisional
Performance
Lecture 10
Ramia Kiran
To describe and assess the impact of transfer
prices on divisional performance evaluation.
Transfer Pricing

• Transfer price is the price at which goods and services are

transferred from one division to another division within
same organization in order to calculate each division's
Profit & Loss separately.
 Is it only Book-
When Needed keeping?

• A transfer pricing policy is needed when:

• an organisation has been decentralised into divisions; and
• inter-divisional trading of goods or services occurs.
• Transfers between divisions must be recorded in monetary terms as
revenue for supplying divisions and costs for receiving divisions.
 RI
Controllable Profit From Operations
Revenue – Externally
Internal Transfer – Value (Cost + Profit)

Marginal Cost- Cost of producing one Extra unit (Variable Cost)

Full Cost – Variable Cost + Fixed Cost

Implications!

Price – Full Cost + profit Margin

Objectives of Transfer Pricing

• Goal congruence
• Fairness If Conflict in these then?
• Divisional Autonomy P1 = GC

• Divisional Profit
• Book keeping
• Minimize global tax liability
ABC Consulting has offices in several major cities in Central Europe. Sometimes consultants in one
office work on projects for other offices. The transfer price charged is $1,100 per day of consulting.
The managing director of the Budapest office of ABC Consulting discovered that he could hire reliable
consultants on a freelance basis for $500 per day. On a recent project, in July, he used the services of
a local freelance consultant for five days, paying $2,500 in total. "I've saved the Budapest office
$3,000!" he declared triumphantly at the end of the week.
During the week in question, the Prague office of ABC Consulting had a free consultant who could
have done the work that the freelance consultant was hired to do. This consultant earns a fixed salary,
so the additional cost to the company of this consultant working on the project in Budapest would have
been a flight ticket of $500 and accommodation of $500 in total.
The decision of the managing director of the Budapest office to hire the freelance consultant cost the
ABC Group an additional $1,500 (the fee paid to the freelance consultant of $2,500 less the savings
on travel and accommodation of $1,000).
This is an example of goal incongruence. The managing director of the Budapest office has made a
decision that is good for the Budapest office but not for the overall group. The reason for this was that
the internal transfer price was too high.
Rules – Setting Transfer Pricing
Rule # 1
There is a perfectly competitive market for the product/service transferred
Transfer price = market price

A perfect market means:

• Only one price in the market,
• No buying and selling costs and
• Market is able to absorb the entire output of the primary division and
• Meet all the requirements of the secondary division.
Rules – Setting Transfer Pricing
Rule # 2
Selling division has surplus capacity - TP Negotiated B/W
 Surplus Capacity

Production Capacity = 200,000

Market Demand = 150,000 (Market Price)

Surplus Capacity = 50,000
Negotiate
Seller – Minimum Price – Marginal Cost
Buyer – Maximum Price (Lower of)
• Externally buying price of product
• Net Marginal Revenue = Revenue – Marginal Cost
Rules – Setting Transfer Pricing
Rule # 3
Selling division does not have any surplus capacity - TP Negotiated B/W
Capacity is 200,000 – Buyer in Market

Actual Production 150,000

Seller – Marginal Cost – Opportunity Cost

Buyer
Transfer Pricing - Example
M co has been offered supplies of special ingredient Z at a transfer price of $15 per kg by
H co, which is part of the same group of companies. H co processes and sells special
ingredient Z to customers external to the group at $15 per kg. H co bases its transfer
price on total cost plus 25% profit markup. Total cost has been estimated as 75% variable
and 25% fixed.

$ 15 (Cost + profit) (100+25%) 15/125* 100 = $ 12 Full Cost + $ 3 Profit

Variable Cost $ 12 *75%= $9 , Fixed Cost $ 3

Required:
Discuss the transfer prices at which H co should offer to transfer special ingredient Z to
M co in order that group profit maximising decisions may be taken on financial grounds
in each of the following situations.
Transfer Pricing - Example
Situation #1

• H co has an external market for all its production of special ingredient Z at a selling
price of $15 per kg. Internal transfers to M co would enable $1.50 per kg of variable
packing cost to be avoided.

Perfectly Competitive Market – Transfer Price = Market price

$15-$1.5=$13.5

Buyer Division -
Transfer Pricing - Example
Situation # 2
Conditions are as per (i) but H co has production capacity for 3,000kg of special
ingredient Z for which no external market is available.
For 3,000
Selling 15
Cost 12
Profit 3

12*.75 = $9 Variable cost – $1.5= $7.5

Remaining -- $15-$1.5=$13.5
 Selling division – Offer Price
Maximizing Profit of Group
Spare Capacity - Seller

NO of Product. (Perfectly Competitive market) = Transfer Price = Market Price –

Variable cost that can be avoided ($15-1.5) =$ 13.5

Spare Capacity = 3,000 items (marginal Cost)

Variable/ Marginal Cost = $ 9 – $ 1.5 = $ 7.5
Transfer Pricing - Example

Situation # 3
Conditions are as per (ii) but H co has an alternative use for some of its spare production
capacity. This alternative use is equivalent to 2,000kg of special ingredient Z and would
earn a contribution of $6,000.
For 2,000
$7.5 + $ 3(Opp. Cost)= $10.5
For 1,000 = $7.5

Remaining -- $15-$1.5=$13.5
3,000
2,000 Contribution Can be $ 6,000 (6,000/2,000)= $ 3
1,000 Spare Capacity

Perfectly Competitive Market = $ 15 -$1.5 = $ 13.5

1,000 Spare Capacity = $ 9 – $ 1.5 = $ 7.5
2,000 capacity – Marginal Cost + Opportunity Cost
= $ 7.5 + $ 3 = $ 10.5
Practical Methods –Transfer Pricing
Market Based Approach
• Perfectly competitive market exists for the product,
• Market price is the best transfer price.
• Adjusted market price for costs not incurred on an internal transfer, e.g. delivery costs.

Cost Based Approach

• NO Perfectly competitive market exists for the product,
• Cost + % profit.
• Can be Marginal cost – Preferred by the buying division
• Full cost – Preferred by the selling division
• Opportunity cost – if there is no spare capacity in the selling (the opportunity cost should
be added to the marginal cost/full cost).
Practical Methods –Transfer Pricing

Others

• Marginal cost plus a lump sum (two part tariff) – the selling division transfers each
unit at marginal cost and a periodic lump sum charge is made to cover fixed costs.

• Dual pricing – the selling division records one transfer price (e.g. full cost + % profit)
and the buying division records another transfer price (e.g. marginal cost). This will be
perceived as fair but will result in the need for period-end adjustments in the accounts
Transfer Pricing - Example
X, a manufacturing company, has two divisions: Division A and Division B.
Division A produces one type of product, ProdX, which it transfers to Division
B and also sells externally. Division B has been approached by another
company which has offered to supply 2,500 units of ProdX for $35 each.

The following details for Division A are available:

Sales revenue: $
Sales to division B @ $40 per unit 400,000
External sales @ $45 per unit 270,000
less:
Variable cost @$22 per unit 352,000
Fixed costs 100,000
–––––––
Profit 218,000
–––––––
Transfer Pricing - Example

External sales of Prod X cannot be increased, and division B decides to buy from the
other company.

Required:
• Calculate the effect on the profit of division A.
• Calculate the effect on the profit of company X.
 Effect on profit Division A

2,500 units * 40 p Unit = $ 100,000

2,500Units * 22 Punit = (55,000)
$ 18 Punit 45,000 Reduction
 Company X - profit

External Buy = $ 35
Internally Variable cost = ($ 22)
$13 * 2500 =

Division A $40 Revneue

Division B $ 40 Cost
Transfer Pricing - Example
Division A will lose the contribution from internal transfers to Division B.
Contribution foregone = 2,500 × $(40 – 22) = $45,000 reduction.

Company X
$ per unit
Cost per unit from external supplier 35
Variable cost of internal manufacture saved 22
–––
Incremental cost of external purchase 13
–––
$13 × 2,500
Reduction in profit of X = units
= $32,500
International Transfer Pricing

Taxation
The selling and buying divisions will be based in different
countries.

Different taxation rates in these countries allows the

manipulation of profit through the use of transfer pricing.
International Transfer Pricing
Remittance controls
• A country's government may impose restrictions on the transfer of
profits from domestic subsidiaries to foreign multinationals.
• This is known as a 'block on the remittances of dividends' i.e. it limits
the payment of dividends to the parent company's shareholders.
• It is often done through the imposition of strict exchange controls.
• Artificial attempts at reducing tax liabilities could, however, upset a
country's tax authorities. Many tax authorities have the power to alter
the transfer price and can treat the transactions as having taken place
at a fair arm's length price and revise profits accordingly.
International Transfer Pricing - Example
Rosca Coffee is a multionational company. Division A is based in Northland, a country
with a tax rate of 50%. This division transfers goods to division B at a cost of $50,000 per
annum. Division B is based in Southland, a country with a tax rate of 20%. Based on the
current transfer price of $50,000 the profit of the divisions and of the company is as
follows:
Division A Division B Company
($) ($) ($)
External sales 100,000 120,000 220,000
Internal transfers to div B 50,000 – 50,000
Fixed and variable costs (70,000) (40,000) (110,000)
Transfer costs from div A – (50,000) (50,000)
––––––– ––––––– –––––––
Profit before tax 80,000 30,000 110,000
Profit after tax 40,000 24,000 64,000
International Transfer Pricing - Example
Rosca Coffee want to take advantage of the different tax rates in
Northland and Southland and have decided to reduce the
transfer price from $50,000 to $20,000. This will result if the
following revised profit figures:
Division A Division B Company
($) ($) ($)
External sales 100,000 120,000 220,000
Internal transfers to div B 20,000 – 20,000
Fixed and variable costs (70,000) (40,000) (110,000)
Transfer costs from div A – (20,000) (20,000)
––––––– ––––––– –––––––
Profit before tax 50,000 60,000 110,000
Profit after tax 25,000 48,000 73,000
International Transfer Pricing - Example

Conclusion:

the manipulation of the transfer price has increased the

company's profits from $64,000 to $73,000.