41. Transfer Pricing

Question 1

Why is transfer pricing needed?

Answer 1

• It can be used to motivate performance and discipline processes in cost and revenue centers.
• It allows both cost and revenue centers to be reestablished as profit centers to better align incentives with the organization.
• 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 quality and timeliness.

Question 2

Describe the first issue that needs to be clearly managed and separately evaluated when managing transfer pricing.

Answer 2

• Does the organization want the transfer to take place between the two business units?
• The organization should determine if there is an outside alternative and, if there is, the organization must determine if it is cheaper to buy externally or internally produce and transfer the product by comparing the external market price to the sum of the variable cost, opportunity cost, and incremental fixed cost.

Question 3

Assuming the organization wants the transfer to take place, describe the second issue that needs to be clearly managed and separately evaluated when managing transfer pricing.

Answer 3

• What should the transfer price be so both units will be incentivized to participate?
• The supplying unit needs to cover its variable costs, plus any opportunity costs of making the transfer and any incremental fixed costs.
• The receiving unit does not want to pay more than the price available in the external market, although it may be willing to pay more if the difference is offset by transaction savings.

Question 4

How will the transfer price be set when there is production capacity and when the production capacity is running out?

Answer 4

• When there is production capacity, business units will negotiate the transfer price somewhere between the variable cost plus the average of any incremental fixed costs to produce as the floor, and the market price that the receiving unit would normally pay as the ceiling.
• If the supplying unit is running out of production capacity, the supplying unit will include the lost contribution margin on outside business in the price floor. Therefore, the formula for the minimal transfer price will equal (total variable costs + contribution margin lost + incremental fixed costs) ÷ total units supplied.

Question 5

What is one major benefit and one major drawback of using transfer pricing to create an open market within the organization?

Answer 5

• Benefit: This approach creates positive competitive pressure to keep costs down and quality up on goods and services being delivered within the organization.
• Drawback: Managers sometimes make suboptimal decisions when choosing to transfer (or not) due to poor accounting information or misaligned incentives. It can be tempting for the executive management team to step in, but that is generally not advisable because other benefits related to delegation and management training are lost

Question 6

What are some of the international issues that organizations with business units spread across different economic zones need to manage?

Answer 6

• Organizations that do transfer pricing across multiple economic zones need to manage issues such as tax rates, tariffs, exchange rates, and currency restrictions when deciding whether to conduct an internal transfer and what transfer price to use.
• Because most governments pay close attention to companies that use internal transfer prices primarily to work around different laws, there is significant regulation involved in the process.