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Prepared by Diane Tanner University of North Florida

Chapter 47. Transfer Pricing. Prepared by Diane Tanner University of North Florida. What is Transfer Pricing?. 2. The price that one division of a company charges another division of the same company for a product or service transferred between the two divisions or segments.

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Prepared by Diane Tanner University of North Florida

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  1. Chapter 47 Transfer Pricing Prepared by Diane Tanner University of North Florida

  2. What is Transfer Pricing? 2 The price that one division of a company charges another division of the same company for a product or service transferred between the two divisions or segments • The goal is to choose a transfer price that adds the most value to the total company.

  3. Key Points Affecting Prices • When a division sells a product/service to another division in the same company, • There are no cash flows between the divisions • Transfer price is used only for accounting purposes • The exchange creates • An expense for the division receiving the goods or services, and • A revenue for the division providing the goods or services • Transfer prices affect division profits, not the whole company's profits

  4. Transfer Price Approaches • Best transfer price • One that causes division managers to act in the best interest of the entire company • I.e., creates the most total profit for the company • Frequently used approaches to setting transfer prices 1.    cost to the selling division - variable costs only 2.    cost to the selling division - full costing 3.    negotiated transfer prices 4.    market price

  5. Cost-based Transfer Pricing • Based on the cost to the division providing the good or service • Two options • Variable costs of the division providing the goods or services. • Disadvantages: Does not cover fixed costs • Full costing (absorption) of the division providing the goods or services • Disadvantages: May lead to sub-optimization due to fixed costs when fixed costs are not relevant are mixed with variable costs • Both options provide no incentives to managers to control costs • Why? The division providing the goods or services knows whatever cost is passed on will be recovered.

  6. Negotiated Transfer Pricing • Managers of the divisions involved get together and negotiate a price • An acceptable transfer price must be: • Both divisions will have profit increases. • Lower limit is determined by the selling division.  I won't take less than $xx. • Upper limit is determined by the buying division. 'I won't pay more than $xx"

  7. Market Price • Market price is the amount charged for an item on the open market. • Usually the best approach to transfer pricing • Works best if: 1. The selling division has no idle capacity, and 2.  The product is sold to outside customers (with no process further adjustments)

  8. International Aspects of Transfer Pricing Between divisions outside the US has advantages that enhance the selling company 1. Taxes and tariffs are smaller when lower transfer prices are used 2. Foreign exchange pricing risks are less when lower transfer prices are used 3. Relations with foreign governments are improved

  9. The End

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