Transfer Pricing

1. Transfer Pricing rights reserved.

2. 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 19th (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

3. © 2012 Pearson Prentice Hall. All rights reserved.

4. Class Objectives • Understanding transfer pricing as an internal pricing mechanism • Understanding transfer pricing as a means for evaluation • Consider the implications of transfer pricing on behaviour

5. 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. © 2012 Pearson Prentice Hall. Aill rights reserved.i

6. 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 subunit’s 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.

7. 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 company’s profit). • 3) To evaluate segment performance • 4) To minimize taxes, duties & tariffs for multinationals • 5) Preserve autonomy

8. 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

9. Transfer Pricing: Methods Difficulty in implementing this rule yielded three approaches to determining transfer price. • Market-based transfer prices • Cost-based transfer prices • Hybrid transfer prices • Prorated transfer prices • Dual transfer prices • Negotiated transfer prices © 2012 Pearson Prentice Hall. All rights reserved.

10. 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: • The market for the intermediate product is perfectly competitive. • Interdependencies of subunits are minimal. • 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.

11. 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 division’s operating income (cost management) © 2012 Pearson Prentice Hall. All rights reserved.

12. 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

13. 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.

14. 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)

15. 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.

16. 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.

17. 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.

18. 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.

19. Transfer Pricing: Method Comparison © 2012 Pearson Prentice Hall. All rights reserved.

20. 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 Transfer Pricing: International

21. Midterm • 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 18th – 11:00am – 1:00pm (normally none) • Wednesday 19th – 9:00am – 2:00pm (normally 11:00am – 2:00pm)