CAE 24 – STRATEGIC BUSINESS ANALYSIS

TRANSFER PRICING
SUMMARY:
External Sales
 Some of the many factors that can affect pricing decisions include:
a. Pricing Objectives
• Gain market share
• Achieve a target rate of return
b. Environment
• Political reaction to prices
• Patent or copyright protection
c. Demand
• Price sensitivity
• Demographics
d. Cost Considerations
• Fixed and variable costs
• Short-run or long-run

 In most cases, a company does not set prices. Instead the price is set by the competitive market
(laws of supply and demand). These companies are called price takers and price taking often happens when the
product is not easily differentiated from competing products, such as farm products (corn or wheat) or minerals
(coal or sand).

 Companies can set prices

(1) where the product is specially made for a customer,
(2) when there are few or no other producers capable of manufacturing a similar item, or
(3) when a company can effectively differentiate its product or service from others.

Pricing in a Competitive Market

 Once a company has identified its segment of the market, it does market research to determine
the target price. The target price is the price that the company believes would place it in the optimal position for
its target audience. Once the company has determined the target price, it can determine its target cost by setting a
desired profit. The difference between the target price and the desired profit is the target cost of the
product. The target cost includes all product and period costs necessary to make and market the product.
 CAE 24 – STRATEGIC BUSINESS ANALYSIS

Cost-Plus Pricing

 When the price is set by the company, price is commonly a function of the product or service. Cost-plus
pricing involves establishing a cost base and adding to this cost base a markup to determine a target
selling price. The size of the markup (the “plus”) depends on the desired operating income return on investment
(ROI) for the product line, product, or service.
The cost-plus pricing formula is expressed as follows:
Target selling price = Cost + (Markup Percentage X Cost)

 The cost-plus approach has a major advantage: it is simple to compute. However, the cost model
does not give consideration to the demand side—that is, will the customers pay the price. In addition, sales
volume plays a large role in determining per unit costs. The lower the sales volume, the higher the price a
company must charge to meet its desired ROI (because fixed costs are spread over fewer units and therefore the
fixed costs per unit increases).

 Instead of using both fixed and variable costs to set prices, some companies simply add a markup
to their variable costs. Using variable costing as the basis avoids the problem of using poor cost information
related to fixed cost per unit computations.

Time and Material Pricing

 Under time and material pricing, the company sets two pricing rates—one for the labor used on a job and
another for the material. The labor rate includes direct labor time and other employee costs. The material charge
is based on the cost of direct parts and materials used and a material loading charge for related overhead costs.
 Using time and material pricing involves three steps:
(1) calculate the per-hour labor charge,
(2) calculate the charge for obtaining and holding materials, and
(3) calculate the charges for a particular job.

The per-hour labor charge typically includes the direct labor cost of an employee, selling, administrative, and
similar overhead costs, and an allowance for a desired profit of employee time. The charge for materials
typically includes the invoice price of any materials used on the job plus a material loading charge. The charges
for any particular job are then a result of (1) the labor charge, (2) the direct charge for materials, and (3) the
material loading charge.
 CAE 24 – STRATEGIC BUSINESS ANALYSIS

To illustrate a time and material pricing situation, assume the following data for Rancho Park Golf
Club Repair Service:

Rancho Park Golf Club Repair Service

Budgeted Costs for the Year 2019
Time Material
Charges Charges
Repair service employee wages $26,000 $ 5,000
Administrative assistant salary 1,950 1,000
Other overhead (supplies, depreciation,
advertising, utilities) 4,940 3,000
Total budgeted costs $32,890 $ 9,000

Step 1: During 2019 Rancho Park budgets 1,300 of hours for repair time, and it desires a profit margin of $6 per
hour of labor. Computation of the hourly charges is as follows:
Per Hour
Per Hour Total Cost ÷ Total Hours = Charge
Hourly labor rate for repairs:
Repair service employee $26,000 ÷ 1,300 = $20.00
Overhead costs:
Administrative assistant 1,950 ÷ 1,300 = 1.50
Other overhead 4,940 ÷ 1,300 = 3.80
$32,890 ÷ 1,300 = $25.30
Profit margin 6.00
Rate charged per hour of labor $31.30
 CAE 24 – STRATEGIC BUSINESS ANALYSIS

Step 2: Rancho Park estimates that the total invoice cost of parts and materials used in 2019 will be $30,000 and
it desires a 10 percent profit margin markup on the invoice cost of parts and materials. The computation of the
material loading charge used by Rancho Park during 2019 is as follows:
Total Invoice Material
Material ÷ Cost, Parts = Loading
Total Cost and Materials Charge
Overhead costs
Parts manager salary $5,000
Administrative assistant 1,000
6,000 ÷ $30,000 = 20.00%
Other overhead 3,000 ÷ 30,000 = 10.00%
$9,000 ÷ 30,000 = 30.00%
Profit margin 10.00%
Material loading charge 40.00%

Step 3: Rancho Park prepares a price quotation to estimate the cost to fix a set of woods for a patron. Rancho
Park estimates the job will require a half hour of labor and $150 in parts and materials. Rancho Park’s price
quotation is as follows:
Rancho Park Golf Club Repair Service
Time and Materials Price Quotation

Job: Arnold Palmer, repair of set of woods

Labor charges: half hour @ $31.30 $ 15.65

Material charges
Cost of parts and materials $150.00
Material loading charge (40% X 150) 60.00 210.00
Total price of labor and materials $225.65
 CAE 24 – STRATEGIC BUSINESS ANALYSIS

Internal Sales

Divisions within vertically integrated companies normally transfer goods or services to other divisions within the
same company, as well as to customers outside the company. When goods are transferred internally, the
price used to record the transfer between the two divisions is called the transfer price.
Three possible approaches for determining a transfer price are (1) negotiated transfer prices, (2) cost-based
transfer prices, and (3) market-based transfer prices.

Negotiated Transfer Prices

The negotiated transfer price is determined through agreement of division managers. Using the negotiated
transfer pricing approach, a minimum transfer price is established by the selling division, and a maximum
transfer price is established by the purchasing division.
Calculating the minimum transfer price depends on whether the selling division has excess capacity or not.
If the selling division has no excess capacity, then the minimum transfer price is the variable cost plus its
lost contribution margin (also known as opportunity cost).
If the selling division has excess capacity, then the minimum transfer price is the variable cost.

Cost-Based Transfer Prices

Another method of determining transfer prices is to base the transfer price on the costs incurred by the division
providing the goods.
If a transfer price is used, the transfer price may be based on variable costs alone, or on variable costs
plus fixed costs. A markup may be added to these cost numbers. This method, however, may lead to a loss of
profitability for the company and unfair evaluations of division performance.

Market-Based Transfer Prices

The market-based transfer price is based on existing market prices of competing goods or services. A market-
based system is often considered the best approach because it is objective and generally provides the proper
economic incentives. Unfortunately, however, there is often not a well-defined market for the good or
service being transferred and thus companies resort to a cost-based system.
 CAE 24 – STRATEGIC BUSINESS ANALYSIS

Transfers Between Divisions in Different Countries

As more companies “globalize” their operations, an increasing number of transfers are between divisions that
are located in different countries. Companies must pay income tax in the country where income is generated. In
order to maximize income, and minimize income tax, many companies prefer to report more income in
countries with low tax rates, and less income in countries with high tax rates. This is accomplished by
adjusting the transfer prices they use on internal transfers between divisions located in different
countries. The division in the low-tax-rate country is allocated more contribution margin, and the
division in the high-tax-rate country is allocated less.

*Absorption Cost Pricing

*Absorption cost pricing is consistent with generally accepted accounting principles (GAAP) because it
defines the cost base as the manufacturing cost. Both variable and fixed selling and administrative costs are
excluded from this cost base. Thus, selling and administrative costs plus the target ROI must be provided
through the markup.
The steps in using the absorption cost approach are as follows:
a. Compute the unit manufacturing cost.
b. Compute the markup percentage using the formula:
Desired Selling and
ROI per unit + Adminstrative = Markup Percentage X Manufacturing Cost Per Unit
Expenses Per Unit

c. Set the target selling price using the formula:

Manufacturing + Markup X Manufacturing = Target Selling Price
Cost Per Unit Percentage Cost Per Unit
 CAE 24 – STRATEGIC BUSINESS ANALYSIS

*Variable-Cost Pricing

*Under variable-cost pricing, the cost base consists of all of the variable costs associated with a product,
including variable selling and administrative costs. Because fixed costs are not included in the base, the
markup must provide for fixed costs (manufacturing and selling and administrative) and the target ROI.
The contribution approach is more useful for making short-run decisions because it displays variable cost and
fixed cost behavior patterns separately.

The steps in using the contribution approach are as follows:

a. Compute the unit variable cost.
b. Compute the markup percentage using the formula:
Desired ROI Per Unit
+ = Markup Percentage X Variable Costs Per Unit
Fixed Costs Per Unit

c. Set the target selling price using the formula:

Variable Cost Per Unit + ( Mark up Percentage X Variable Cost Per Unit ) = Target Selling Price

Source:

Weygant, Kimmel, Kieso , Managerial Accounting; 6th Edition