Transfer pricing

Definition
 The price at which products or services are transferred
between subunits within the same corporation.
– It affects the revenues of the producing profit center (PC),
the costs of the buying PC, and hence, the profits of both
entities.

 Purposes
– Provide proper economic signals so that PC managers make
good economic decisions from a corporate standpoint;
– Provide information for evaluating PC performance (i.e., control);
– Purposely move profits between company entities/locations.
» e.g., for tax purposes.
Transfer price satisfying goal and
behavioural congruence
 The transfer price should be chosen so that each division
manager, when striving to maximize his/her own division’s
profit, makes the decision that maximizes the company’s
profit. –This is goal congruence.

 General transfer pricing rule to ensure goal congruence:

Transfer price = Additional cost per unit incurred up to the point

of transfer + Opportunity cost per unit to the organization
because of the transfer

Recall: an opportunity cost is a benefit (in our case, contribution

margin) forgone as a result of taking a particular action.
Why does the general rule promote goal
congruence
 Suppose the company has two divisions: the production
division (S) and the retail division (B). S incurs the
following cost to produce a backpack:
Standard unit-level production cost $39
Standard unit-level transportation cost $1

 No excess capacity: division S can sell all its products it

can produce at a market price of $60 each.
– Contribution margin is 60 – (39+1)= $20, this is the opportunity
cost
– Following the general rule, transfer price is 40+20=$60
– Does this price ensure goal congruence?
Why does the general rule promote goal
congruence
 No excess capacity
– Suppose retail division (B) can sell a backpack for $70 each.
– Contribution to company from S selling to external market:
» 60 – 40 = $20
– Contribution to company from S selling to B (internal transfer):
» 70 – 40 = $30
– Because of no excess capacity, the best use of the limited
capacity of S is produce backpacks for transfer to B
» If the transfer price is set at $60, then S is willing to transfer to B
because the transfer price equals external market price. B is willing
to buy from S because B will have a contribution margin of $10 (70
– 60).
» What is best for the division(s) is also the best for the company:
goal congruence is achieved.
Why does the general rule promote goal
congruence
 No excess capacity
– Now suppose a local buyer makes a special offer to B:
paying a $55 price to buy backpacks from B. B will
decline to offer as B will lose $5 per backpack (55 –
60).
» If B accepts the offer, the contribution margin to the company
is $15 (55 – 40).
» But the company is better off if S sells directly to the external
market at $60, yielding a $20 contribution margin (60 – 40).
» The company as whole is better off if B rejects that special
offer
» Again, division (B)’s decision is consistent with what’s best for
the company: goal congruence is achieved.
Why does the general rule promote goal
congruence
 Excess capacity: assume production division S has
idle capacity. The opportunity cost is therefore 0.
 Under the general rule, the transfer price is $40
(incremental cost + 0 opportunity cost)
 Again, retail division B receives a special offer from a
local customer to buy backpacks from B at $55 per unit.
– B’s contribution margin is $15 (55 – 40) per backpack if
accepting the offer. It is in B’s best interest to buy from S.
– The contribution margin for the company as a whole is also $15
for each backpack S transfers to B.
– Goal congruence is achieved: S transfers to B when then sells
to the local customer.
Implementing the general rule
 Note that the general rule yields a transfer price that
leaves the production division (S) indifferent between
making the transfer or not
– No excess capacity: the $60 price yields a contribution margin of
$20 regardless of transferring internally or not
– Excess capacity: the $40 price yields a 0 contribution regardless
of transferring internally or not
 To avoid this problem, we can view the general rule as
providing a lower bound on the transfer price (i.e.,
minimum transfer price).
– Company can allow the production (i.e., selling) division to add a
markup to this lower bound, providing a positive incentive to
make the transfer.
Difficulty in implementing the general rule
 Perfect competition: market price is “fixed” and does not depend
on the quantity sold by any one producer. Thus, opportunity cost
caused by internal transfer can be accurately measured.
 Imperfect competition: external market price depends on the
producers’ production decisions.
– Imperfect competition: the potential of the selling division to influence
quantity demanded and profit through prices complicates the
measurement of opportunity cost
– Opportunity cost depends on (i.e., price is negatively related to) the
quantity sold externally. Transfer price depends on constantly changing
levels of supply and demand. There is not just one transfer price
– Transfer prices for various quantities supplied and demanded depend
on the incremental costs and opportunity costs of the units transferred.
– These interactions make accurately measuring the opportunity cost
caused by an internal transfer impossible
Types of transfer price

 Market-based transfer prices

 Cost-based transfer prices

– Full cost bases
– Variable cost bases

 Hybrid transfer prices

– Prorating the difference between maximum and minimum
transfer prices
– Dual pricing
– Negotiated transfer prices
Transfer Pricing Illustration
Transfer Pricing Illustration
Market-based transfer prices
 Actual price charged to external customers, listed price of a
similar product (e.g. from trade association), or the price a
competitor is offering (bid price).

 Deviations can be allowed that reflect differences between

internal and external sales:
» Savings in marketing, selling, and collecting costs;
» Differences in quality standards, special features, or special
services provided

 Perhaps should not be used if the market is currently in a state of

“distress pricing”
– Market price temporarily drops below historical average; but difficult to
determine whether price is distress
– Some use long-run average prices if suspecting of distress prices
Market-based transfer prices

 Lead to optimal decision-making when three

conditions are satisfied:

1. The market for the intermediate product is perfectly

competitive
 Can accurately measure the opportunity cost (contribution margin
forgone) of internal transfer
 Price is fixed

2. Interdependencies of subunits are minimal

3. 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
Market-based transfer prices

 The general rule of transfer pricing (i.e., the transfer

price achieving goal congruence) can be easily
implemented if the market is in perfect competition.
– (minimum) transfer price = incremental cost + opportunity cost
– Opportunity cost is contribution margin forgone, which in turn
depends on selling price in the external market
– Selling price in the external market is fixed (i.e. does not
depend on whether the selling division sells in the external
market or not)
– Thus opportunity cost can be measured accurately
– Thus goal congruence transfer price can be calculated
accurately and easily
Market-based transfer prices
 Perfect competition is required for transfer price to achieve goal
congruence, subunit performance evaluations and autonomy
– Suppose perfect competition price is $85:
– transfer price<$85, selling division will sell externally (close buying)
» Buying division incurs a loss at the price of $85 (e.g., buying
division’s variable cost is $2 and can only sells to its customers at
$86)  selling externally maximizes company profit
– transfer price>$85, buying division will buy externally (close
selling)
» Selling division incurs a loss at the price of $85, can’t compete in the
perfectly competitive market buying externally at $85 maximizes
company profit
– Using market based transfer prices, the firm is not subsidizing any
division, whereas the firm may be subsidizing “undeserving”
operations without knowing it if using cost based transfer prices
– Transfer price=$85 will motivate both divisions to deal internally
as neither is better off by dealing in the external market. $85 max
profits of both divisions and of the company. Managers exert effort
to reduce costs as transfer price is not based on costs.
 Market-based transfer prices
 Imperfect competition (price can be influenced): selling unit can choose price-
quantity combination that max it’s profit if it sells in external market. If transfer
price is set at this selling price, buying unit may decide not to purchase from
selling unit as it finds the price is too high resulting in a loss. This creates goal
incongruence if it is in the company’s best interest for buying unit to purchase
from selling unit for further processing and sale. To illustrate:
– Selling division S has capacity of 15 units and a variable cost per unit of $2. It faces a
downward sloping demand curve P=20-Q. Profit function is (20-Q)Q-2Q. Optimal Q is
9 units and price is $11 (=20-9) and the max profit is $81. Suppose division B can buy
the product from S and incurs a variable cost of $4 per unit for further processing and
sell the final product at $12. Since S has excess capacity of 6 units. It is in the firm’s
interest to have S make the additional units and transfer to B. The firm makes an
incremental profit of 12-2-4=$6 for each transferred unit. However, if the transfer price
is the market price of $11, B would reject the transaction (12-11-4=-$3).
– To resolve this, the transfer price has to be lower than the market price. It has to be
greater than S’s variable cost ($2) and less than B’s contribution margin ($8). In other
words, the transfer price has to be discounted relative to market price ($11) by at
least $3.
Marginal cost transfer prices
 It excludes upstream fixed costs and profits, and
hence, the marginal costs remain visible for the
PC that finally sells to outside customers. This
transfer price is based on variable costs.
 It provides poor information for evaluation purposes
(i.e., not suitable for control purpose)
» The selling PC incurs a loss;
» The profits of the buying PC are overstated.

 Rarely used in practice

 Variation: Marginal cost and lump-sum fee
» The marginal cost of the transfer remains visible;
» The selling PC can recover its fixed cost and a profit margin
through the lump-sum fee;
Full-cost transfer prices
 Popular in practice

 Relatively easy to implement

» Firms have cost systems in place to calculate the full cost of
production;
» But, full costs rarely reflect actual, current costs of producing
the products because of financial accounting conventions
(e.g. depreciation) and arbitrary overhead cost allocations.

 There is no incentive for the selling PC to transfer

internally since there is no profit margin.

 The profit of the selling PC is understated.

Full-cost and mark-up

 It allows the selling PC to earn a profit on

internally transferred products/services.

 Crude approximation of the market price in

cases where no competitive external market
price exists.
– Such transfer prices, however, are not responsive
to market conditions.
Summary of full cost and cost plus
methods

 Advantages
– Easy to calculate: just cost numbers
– Easy to understand
 Disadvantages:
– When there is excess capacity (in the selling division), the
use of full cost or full cost plus markup can result in poor
decision making (see next slide)
– Selling division has little incentive to control costs: no matter
what, selling division always has 0 profit (full cost case) or a
fixed markup (full cost plus markup case)
– Full cost: selling division has no profit, unwilling to do
internal transfer
Full-cost and mark-up

 It can lead to suboptimal decisions.

 The company has a Refining Division (RD) in Houston, and a
Transporting Division (TD) in Matamoros where it has pipelines.
 Suppose company’s internal transfer price is 105% of full cost.
 RD can purchase 20000 barrels of crude oil per day from a local
(Houston) supplier at a price of $85 per barrel (including delivery
etc.).
 RD finds another supplier of crude oil, called Gulf. Gulf can deliver oil
to Matamoros (to TD) at a price of $79, then sell it to RD through TD’s
pipeline.
 The variable cost of TD’s pipeline is $1 per barrel transported.
(unavoidable) fixed cost is $3 per barrel. And the pipeline has un-
used capacity.
Full-cost and mark-up

 Alt 1: buy from local supplier at $85. Total costs to

company are 20000x85=$1,700,000
 Alt 2: buy in Matamoros (from Gulf) at $79 and
transport to Houston at a VC of $1 per barrel.

 However, transfer price is 105% of full cost.

 Alt 1: $1,700,000
 Alt2:
Full-cost and mark-up

 The variable cost is $80 per barrel ($79 purchase from

Gulf + $1 transport to Houston).

 The $7.15 ($87.15-$80) is TD’s fixed cost and markup.

=>full cost plus markup causes RD to regard fixed cost
(and 5% markup) as variable cost and leads to goal
incongruence.

 Company should force RD to buy from Gulf? But that

goes against the philosophy of decentralization.
Full-cost and mark-up

 What transfer price will promote goal congruence for both TD and
RD?
 If transfer price is below $80, then TD has no incentive to purchase
crude oil from Gulf and transport to RD, as the revenue (transfer
price) is below the incremental cost ($80).
 If transfer price is above $85, then RD will purchase crude oil from
external market, not from TD.
 A transfer price between $80 and $85 promotes goal congruence:
TD and RD increase their own income and income of the whole
company increases too.
– E.g. set it at $83, TD shows no income, evaluate TD as a cost center.
Hybrid transfer prices

 Cost-based transfer pricing alternatives

– Prorating the difference between the maximum and

minimum cost-based transfer prices

– Dual pricing

– Negotiated pricing
Prorating the difference between the maximum
and minimum cost-based transfer prices

– The minimum the selling division wants to receive: $80

– The maximum the buying division is willing to pay: $85

– Budgeted variable cost: selling div $1 x 100 = $100; buying

div $8 x 50 = $400
– Of the $5 difference, selling div keeps (100/500)x5= $1, and
buying div keeps (400/500)x5= $4 => transfer price is $81

– To do this, divisions must share information, and not totally

decentralized
Dual-rate transfer prices

 Using two separate transfer-pricing methods to price

each transfer from one subunit to another. Example:
selling division receives full cost pricing, and the
buying division pays market pricing
– Debit buying division with market price, e.g. $85
– Credit selling division with 105% full-cost price, e.g. $87.15
– Debit a corporate account for the difference, $2.15
– Income for whole company is less than the sum of the
subunits
– Not widely used
Dual-rate transfer prices
 Advantages
» It ensures that internal transactions (if desired by the firm)
will take place
 RD no worse off if it buys from TD rather than buying
externally at $85
 TD receives a corporate subsidy

 Disadvantages
» It insulates managers from marketplace:
 It destroys incentives to improve productivity to reduce
costs (selling division finds easy sales inside)
 Each division has incentives to overstate its variable
costs to receive a more favorable transfer price.
Negotiated transfer prices
 Transfer prices are negotiated between the selling
and buying PC managers themselves.
» Both PC managers should have some bargaining power
(i.e. some possibilities to sell or source outside).

» The outcome is often not economically optimal, but rather

depends on the negotiating skills of the managers involved.

 While preserving division autonomy, it is costly

(management time), accentuates conflicts between PC
managers (they may not cooperate in the best interest of
the firm), and often requires corporate management
intervention.
Comparison of different transfer pricing
methods

Criteria Market-based Cost-based Negotiated

Achieves goal Yes, when markets are Often, but not always Yes
congruence perfectly competitive
Yes Yes, when based on Yes
budgeted costs; less
Motivates subunit
incentive to control
management effort
costs if based on
actual costs
Yes, when markets are Difficult unless transfer Yes, but transfer
perfectly competitive price exceeds full cost prices are affected by
Useful for evaluating
and even then is bargaining strengths of
subunit performance
somewhat arbitrary selling and buying
subunits
Yes, when markets are No, because it is rule Yes, because it is
Preserves subunit
perfectly competitive based based on negotiations
autonomy
between subunits
Markets may not exist, Useful for determining Time consuming and
or markets may not be full cost of products may need to be
Other factors
perfectly competitive and services; easy to reviewed repeatedly
implement as conditions change
Reorganization: solution if transfer pricing
conflicts are serious and all else fails
 Costly transfer pricing disputes among responsibility
centers arise when relative volume of transactions
among divisions is large
– A small change in transfer price can have a large effect on the
division’s reported profit
 Ways of Reorganization
– Combine two profit centers with a large volume of transfers
into a single division
– Convert Manufacturing division into a cost center rather than a
profit center: performance is evaluated based on efficiency in
production (e.g., two divisions: Manufacturing and Distribution)
– Both divisions are organized as cost centers and keep the
pricing and quantity decisions at the central office
Advantages and disadvantages of transfer
pricing methods
Method Advantages Disadvantages

Market-based transfer • Objective, less subject to • Market might not exist

manipulation • Might not capture interdependencies
prices • Leads to correct make/buy decision among divisions

Variable-cost transfer • Approximate marginal cost: facilitate • Does not allow selling division to
decision making by comparing recover fixed cost
prices marginal cost with marginal benefit • Variable cost might vary with output
• Selling division has incentive to
classify fixed costs as variable costs

Full-cost transfer prices • Simplicity • Selling division can export its

• Avoids disputes over which costs are inefficiency to buying division
fixed and which are variable • When there is excess capacity, selling
division overstates cost and buying
division may buy too few units

Negotiated transfer • Both divisions have incentives to • Time consuming

transfer the quantity that maximize • Depends on negotiation skills of the
prices their (combined) profits divisions

Reorganizing the • Eliminate transfer pricing disputes • Reduces the benefits of

decentralization
buying and selling
divisions
Multinational Transfer Pricing and Tax
Considerations

 Transfer prices often have tax implications

 Tax factors include income taxes, payroll taxes,

customs duties, tariffs, sales taxes, value-added
taxes, environment-related taxes and other
government levies

 Suppose division based in country A pays income

tax at 30%, division in country B pays income tax at
20%. If transfer from A to B, then set low transfer
prices, reducing income reported A
Multinational Transfer Pricing and Tax
Considerations

 What if the selling division (manufacturing division) and

buying division (sales division) are both located in high-
tax rate countries?

 For example, the manufacturing division is in Belgium

where the tax rate is 42%, the Belgium division’s product
cost is $100; the sales division is in the US where the tax
rate is 35%, the sales division sells the product it
acquired from the manufacturing division to external
customer at $200 per unit.
Multinational Transfer Pricing and Tax
Considerations

 If the transfer price is set at $200, then

– US division has 0 profit, and pays 0 tax
– Belgium division has a profit of $100, pays $42 tax per unit

 If the transfer price is set at $100, then

– Belgium division has 0 profit, pays 0 tax
– US division has a profit of $100, and pays $35 tax per unit

 What can multinationals do in this situation to evade

tax?
Multinational Transfer Pricing and Tax
Considerations

 Often, multinational companies set up a reinvoicing center in a

country/region with very low tax rate

 A reinvoicing center is a wholly owned subsidiary of the multinational

company. When the manufacturing division and the sales division
reach a transfer agreement, the reinvoicing center takes the title of
the goods but does not physically receive them. The reinvoicing
center then resells the goods to the sales division

 The primary objective of a reinvoicing center is to shift profits to

divisions in low tax countries
Multinational Transfer Pricing and Tax
Considerations

 Continuing with our earlier example, the multinational company sets

up a reinvoicing center in Puerto Rico where the corporate income
tax rate is 0, as a subsidiary.

 Belgium division transfers the title to the product to reinvoicing center

at a price of $100, resulting in 0 profit and 0 tax

 Reinvoicing center then transfers the title to the product to the US

division at a price of $200
– Reinvoicing center has a profit of $100 (200-100),but pays 0 tax
– US division has 0 profit and pays 0 tax
Multinational Transfer Pricing and Tax
Considerations

 Section 482 of the US Internal Revenue Code governs

taxation of multinational transfer pricing, requiring that
transfer prices between a company and its foreign
division or subsidiary equal the price that would be
charged by an unrelated third party in a comparable
transaction (an arm’s-length transaction)
– Transfer price could be market-based or “cost-plus” based

– Specifically, the US IRS allows three methods that

approximate arm’s-length pricing in order of preference:
comparable uncontrolled price method, resale price method,
and cost-plus method
Multinational Transfer Pricing and Tax
Considerations

 Comparable uncontrolled price method is essentially

market price, but adjusted for landing costs (freight,
insurance, etc.) which increase transfer price and
marketing costs which can be avoided for internal
transfers
– E.g. local market price is $50, freight and insurance costs are
$5, and sales commission is $4. Then comparable
uncontrolled price (i.e., market price based transfer price) is
50+5-4=$51
» The freight and insurance costs are necessary as goods move
from one country to another for internal transfers
» No need to pay the sales commission for internal transfers
Multinational Transfer Pricing and Tax
Considerations

 Resale price method is equal to the sales price received

by the reseller (i.e., the buying division) less an
appropriate markup. In other words, the buying division
receives the good for resale sets a transfer price =
resale price – gross profit
– E.g. there is no outside market for the selling division of the
transferred good. The buying division sells the good for $40 and
normally receive a 25% markup on cost of goods sold. Then the
transfer price is calculated using:
resale price = transfer price x (1+markup percentage)
$40 = 1.25 x transfer price
transfer price = 40/1.25=$32
Multinational Transfer Pricing and Tax
Considerations

 Cost-plus method is simply the cost-based transfer

price
– E.g. there is no outside market for the transferred good. The
transferred good is used in the manufacturing of another good
(i.e., it is not resold). Assume that the selling division’s
manufacturing cost for the good is $20, and again assume
that freight in insurance costs are $5. Then the cost-plus
method transfer price is calculated as:
transfer price = manufacturing cost + freight and insurance
= 20 + 5 =$25
Multinational Transfer Pricing and Tax
Considerations

 The determination of an arm’s-length price can be

difficult. The IRS (in the case of the US) permits a
fourth method: a transfer price negotiated between the
company and IRS.
Simultaneous use of multiple transfer
pricing methods

 Transfer pricing for internal purposes

– Decision making and performance evaluation: these two purposes are not
consistent. Managers make decisions in light of the numbers for which
they are evaluated (not necessarily the best decision for the company).
» E.g., variable cost transfer pricing is good for decision making (MR=MC and VC
is approximately MC), but bad for performance evaluation as selling division will
have a loss.
 Transfer pricing for external purposes
– Taxation
 Firms can use one transfer pricing method for internal and one for
external.
 But it is easier for firms to argue that they are not evading taxes using
transfer pricing as the manipulative tool if they use the same transfer
pricing method for tax purposes and for internal purposes.
– For this reason and for system simplicity, multinational firms sometimes avoid using
different transfer pricing methods for domestic and international transfers.