Chapter Five

Transfer Pricing
The whole organization can be divided into a number of divisions; the performance of each
division can be measured in terms of both the income earned and the costs which are incurred. In
profit centered divisional approach the manager of each division is responsible for cost, income
and profit of his division. Further he is given freedom to make all decisions affecting his
division. In such a decentralized organization there may be transfer of goods from one division to
another division. The price charged for transfer of goods of one division to another division is
the cost to receiving division and income of supplying division. It means that the transfer price
fix will affect the profitability of both divisions.
Meaning of transfer pricing
A transfer pricing is the price one subunit (department or division) charges for a product or
service supplied to another subunit of the same organization. Most often the term is associated
with materials, parts, or finished goods.

The transfer price creates revenue for selling subunit (segment producing the product or service)
and purchasing cost for buying subunit. It affects each sub unit operating income. The product
and service transferred between subunit of an organization is called an intermediate product.
This product may either be further worked on by the receiving subunit or, it transferred from
production to marketing, sold to an external customer.
Objectives of transfer pricing system
A transfer pricing system should satisfy three objectives:
 The assessment of divisional performance- Inter-divisional sales will contribute to total
revenues for a division, which in turn influence divisional profit. Setting an appropriate
transfer price can, therefore, be important in deriving a valid measure of divisional profit
for evaluation purposes. This should be of value in helping to establish incentives for, and
promoting accountability of, divisional managers.
 Goal congruence - Divisional managers select actions that maximize firmwide profits.
Transfer prices may seek to optimise profits for the business as a whole. For example, a
division may be prevented from quoting a transfer price for goods that will make buying
divisions seek cheaper sources of supply from outside the business.

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  Preservation of divisional autonomy - Central management should not interfere with the
decision-making freedom of divisional managers. By allowing divisional managers to set
their own transfer prices, and by allowing other divisions to decide whether or not to
trade at the prices quoted, the autonomy of individual divisions is encouraged. This, in

turn, should help motivate divisional managers.

Methods of transfer pricing

A number of different approaches are used to establish a transfer price for goods or services. The
basic caveat is that intercompany transfers should be made only if they are in the best interest of
the total organization. Within this context, the general rules for choosing a transfer price follow:
 The maximum price should be no greater than the lowest market price at which the
buying segment can acquire the goods or services externally.
 The minimum price should be no less than the sum of the selling segment’s incremental
costs associated with the goods or services.
To sum up, transfer prices can be set as low as the variable cost per unit or as high as the
market price. Often, transfer prices are negotiated at some point between variable cost per
unit and market price.
There are three broad categories of methods for determining transfer prices. They are as follows:
1. Market-based transfer prices
2. Cost-based transfer prices
3. Negotiated transfer prices
1. Market-based transfer prices
Under Market-based transfer prices, product of one subunit are transferred to the next or
other subunit at external price. That means the unit transfers outputs at external price that a
subunit charges to out side customers.
If an outside market exists for the product or service transferred, the current market price
may be a proper transfer price.
Transfer Price = Market Price
2. Cost-based transfer prices
Under Cost-based transfer prices, the supplying division transfers the product to the buying
division at the costs of producing them. The costs to be used as a transfer price may be:
 Variable manufacturing costs
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  Absorption manufacturing costs
 All manufacturing costs, including fixed manufacturing costs
 Full product costs
 Includes all production costs, as well as other business functions costs (such as
research and development, design, marketing, distribution, and customer
services)
 Full cost plus mark up:
 Under this method the supplying unit transfers goods and services at full cost plus
some mark-up. The markup added to full cost is may expressed as a percentage of
full cost.
The cost used in cost based transfer prices can be actual costs or budgeted costs. Cost based
transfer price are used when a market price are not available, inappropriate, or too costly to
obtain. The product may be a specialized product, or unique for which price lists are not
available. The internal available product may be different from the products available externally
in terms of quality and services.
3. Negotiated transfer prices
In some case, the subunit of a company are free to negotiate the transfer price between
themselves and then to decide whether to buy and sell internally or deal with outside parties.
Subunit may use information about cost and market price in these negotiations. But there is no
requirement that the chosen transfer prices bear any specific relationship to either cost or market-
price data.
The negotiated price is the out come of a bargaining process between the selling and buying
subunits. The negotiated price approach allows the managers to agree (negotiate) among
themselves on a transfer price. The only constraint is that the transfer price be less than the
market price, but greater than the supplying division’s variable costs per unit, as shown below.
Variable Costs per Unit <Transfer Price per unit < Market Price per unit
Illustration: Star Company has two divisions, Zumra division and Lucy division. Zumra
division produces and sales bags to the other divisions of star company (Lucy division) and to
outside customers. Assume that Zumra division’s cost to produce a single bag is as follows.

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 Zumra division
Cost to Produce 1 Bag
Direct materials $1.00
Direct labor 0.25
Variable overhead 0.25
Fixed overhead ($350,000 /100,000 unit capacity) 3.50
Full manufacturing cost $5.00
The external market price per bag is $10.00

Required:
I. Determine the maximum and minimum transfer price that Zumra Division would accept &
that the manager of Lucy Division would pay.
II. Determine the transfer prices under:
a. The market price method
b. The cost-based method
c. Negotiation method
Solution
I. The maximum and minimum transfer price is $10 &$1.5 respectively. Because transfer
prices can be set as low as the variable cost per unit or as high as the market price per
unit.
II. A. The market price method: The market price is the price that a company would charge to
external customers. It is the maximum price that a buyer should be willing to pay. In this
example, the market price is $10 per bag.
B. The cost-based method: This method uses either the variable cost or the full cost as
the basis for setting the transfer price. At a minimum, the selling division should
recover the incremental (that is, variable) costs of producing and selling the product.
 In this example, the transfer price should be set at no less than the variable cost of
$1.50 per bag.
 Another option is to base the transfer price on the full manufacturing cost of $5.00
per bag, which covers both variable and fixed costs.
 Many companies have a predetermined “cost-plus” transfer price. For example,
Star Company might have a policy of making all internal transfers at the full

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 manufacturing cost plus 10 percent. If so, the transfer price per bag would be
$5.00 + (10% of $5.00) = $5.50. If the transfer price were set at $5.50, both buyer
and seller would benefit from the transfer. The buying division (Lucy division)
would pay $5.50 per bag, a $4.50 savings compared to the market price of $10.00.
The selling division (Zumra division) would make $5.50 minus $1.50 in variable
costs for an increased profit of $4.00 per bag.
C. Negotiation transfer price method
A final option is to let divisional managers negotiate transfer prices. In this method, the
negotiated price can range anywhere from the variable cost ($1.50) to the full market price
($10.00). Negotiating transfer prices can be time consuming and can force managers to act as
adversaries. To avoid such situations, companies may dictate that the buying and selling
divisions split the difference so that each receives an equal benefit from the internal transfer. In
our example, the transfer price would be midway between the $10.00 market price and the $1.50
in variable costs, or $5.75. This approach creates a win–win situation for the managers: The
buying division saves $4.25 per bag ($10.00 − $5.75) by buying from inside and the selling
division makes an extra $4.25 per bag ($5.75 − $1.50) in incremental profit.

3.1. Decentralization verses centralization

 Decentralization is the delegation of manager to make decision. The reason for
decentralization is diverse and complex activities.
 Decentralization is the freedom for managers at lower level of the organization to make
decisions.
 Decentralization empowers managers and employees of sub unit to make decision action.
 Total decentralization means minimum constraints and maximizes freedom for managers
at the lowest level of an organization to make decisions. Whereas, total centralization is
means maximize constraints and minimum freedom for managers at the lowest level of
an organization to make decision. Most company’s structures fall some where in between
these extremes. Decentralization is aid by sophisticated telecommunications such as e-
mail and fax machines. Geographical separation does not create any barrier to
conformation.
 In decentralization organization decision making authority is not confined to a few top
executives; rather, decision making authority is spread through the organization. At one
extreme, a strongly decentralization organization is one in which even the lowest level
managers and employees are empowered to make decision. At the other extreme, in a

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 strongly centralized organization, lower level managers have little freedom to make a
decision.
 Decentralization is a matter of degree of delegation of authority along a continuum. the
continuum is show below
Centralization Decentralization

Maximum constraint minimum constraint

Minimum freedom maximum freedom

Advantage and disadvantage of decentralization

Indeciding how much decentralization is optional, top management try to choose the degree of
decentralization that maximize the excess of benefits over cost. Even though the top management
can not qualify the benefit and / or cost, the cost- benefit approach helps them to determine costs.
 Advantage(benefits) of Decentralization
 Sharpens the focus of subunit managers: in decentralized setting, the manager of small
subunit has concentrated focus. A small sub unit is more flexible and able to move
quickly (nimble) than a large unit. It is also better able to adopt itself quickly to a fast –
opening market opportunity. Decentralization relies (frees) Top management of the
burden of day to day operating decisions. In this case, top management is able to spend
more time and energy on strategic planning, higher level decision making, and
coordinating activities for the entire organization.
 Crates greater responsiveness to local needs: lower level managers have the best
information concerning local condition than top managers. Therefore, lower –level-
managers are often capable of making better operational decisions or may be able to
make better decisions than their superiors. Lower level managers have better information
about their customer, competitors, suppliers and employees. They also have better
information about factors that affect the performance of their jobs such as ways to
decrease costs and improve quality.
 Leads to quicker decision making: since decentralization gives lower level managers
the responsibility to make decision, decision can be made quickly. Quickly decisions
create a competitive advantage over organization that are slower. For example
delegating decision making authority to the sales force allows the organization to respond
quickly to change customers requirement
 Assist management development and learning: decentralization gives managers
decision making ability and other management skill that help them move up ward in the
organization. Giving manager more responsibility helps develop an experienced pool of
management talent to fill hair level of management position.
 Increase motivation of sub unit managers: delegation decision making authority to
lower managers often increase their motivation, resulting in increase job satisfaction and

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 retention, as well as improved performance. Or when lower level manages can exercise
greater individual initiatives, they are highly motivated .decentralization result in
creativity, which in turn, result in productivity.
 Disadvantage(costs) of decentralization
Decentralization has its costs. Some of the costs of decentralization are summarized:
 Leads to sub optional decision making: lower level manager make decisions without
fully understanding the big picture, while top level manager typically have less detailed
information about local operation than lower level managers, they usually have more
information about the company as a whole and should have understanding of the
company’s strategy.
Sub optional decision making may occur
 There is lack of harmony or congruence among over all company goals, the
subunit goals, and the individual goals of decision makers, or
 There is no guidance to subunit managers concerning the effect of their decision
on the other part of the company.
 Is more likely occurred when the subunit in the company are highly
interdependent. Interdependent among unit refers to when the end product of one
unit is the raw material for another unit.
 Focuses the manager’s attention on the subunit rather than the company as a whole:
individual subunit managers may regard themselves as competing with managers of other
subunit in the same company as if they were external rivals. Consequently, managers
may be unwilling to share information or to assist when another subunit faces an
emergency.
 Increasing the cost of gathering information: manager may spend too much time to
obtain information about different subunit of the company to coordinate their action.
(There may be lack of information).
 Result in duplication of activities: several individual subunit of the company may
undertake the same activity separately.
Responsibility accounting
Managers in well organization enterprise identify the responsibility of each subordinate.
These identified responsibilities are called responsibility center. Responsibility center is
defined as a set of activity assigned to a manager or group of manager.
Since decentralization organization delegate decision making responsibility to lower level
manager, they need responsibility accounting system that link lower level manager’s
decision making authority with accountability for the outcomes of those decisions. The
term responsibility center is used for any part of organizations whose manager has
control over and accountable for cost, profit or investment. The three types of
responsibility center are cost center, profit center and investment center.

Cost center:-the manager of a cost center has control over cost, but not over revenueor
investmentfunds. The managers of cost centers are expected to be minimizing cost while
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 providing the level of products and services demanded by other part of the organizations.
Profit center: the manager of profit center has control over both cost and revenue, like a
cost center manager, a profit center manager does not have control over investment
funds. Profit center managers are often evaluated by comparing actual profit to targeted
or budget profit. Profit center generate revenue.
Investment center: the manager of investment center has control over cost, revenue and
investment in operating asset.

Segment reporting and profitability analysis

Effective decentralization requires segmented reporting. Reports are needed for
individual segments of the organizations.A segment is apart or activity of organizations
about which managers would like cost revenue, or profit data. Example of segments
include division of a company sales territories, individual stores, service center,
manufacturing plants, marketing department , individual customer , and product line. A
company operation can be segmented in many ways. In this chapter, we learn how to
construct income statement for business segment. These segmented income statement are
useful in analyzing the profitability of segments and in measuring the performance of
segment managers.
Segmented income statement can be prepared for activity at many levels in a company.
To prepare an income statement for a particular segment, variable expenses are deducted
from sales to yield contribution margin for the segment. The contribution margin tells us
what happens to profit as volume charges holding a segment capacity and fixed cost
constant.

Measuring divisional performance

There are three widely used measurements of divisional performance for the investment center.
These are return on investments, residual income, and economic value added.
1) Return on investment (ROI)
This is the most important ratio calculated by every financial manager. Investment decision and
financing decision are decided based on this ratio.

This ratio indicates the percentage of operating income on total investment in asset of the
business. It also defines as the percentage of operating income to total asset.Return on
investment is a measure as income or profit divided by the investment required to obtained that
income or profit. Return on investment is the best test of profitability.

Because each division of a company has an income statement, couldn’t we simply rank the
divisions on the basis of net income? Unfortunately, the use of income figures alone may provide
misleading information regarding segment performance. For example, suppose that two divisions
report operating profits of $100,000 and $200,000, respectively. Can we say that the second
division is performing better than the first? What if the first division used an investment of
$500,000 to produce the contribution of $100,000, while the second used an investment of $2

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million to produce the $200,000 contribution? Clearly, relating the reported operating profits to
the assets used to produce them is a more meaningful measure of performance.
One way to relate operating profits to assets employed is to compute the profit earned per dollar
of investment. For example, the first division earned $0.20 per dollar invested
($100,000/$500,000); the second division earned only $0.10 per dollar invested
($200,000/$2,000,000). In percentage terms, the first division is providing a 20 percent rate of
return and the second division, 10 percent. This method of computing the relative profitability of
investments is known as the return on investment.
In general, Return on investment (ROI)is the most common measure of performance for an
investment center.
Return on investment is calculated as follows:

ROI = Operating income x 100%

Total asset

Example
Consider two divisions with the following
Division ADivision B
operating income Br. 20,000Br. 25,000
total asset 80,000125,000
required;
a) Compute the return on investment for both division
b) Which division is more profitable?
SOLUTION
a) Division A
ROI = operating income
Total asset
= 20,000 = 25%
80,000
Division B
ROI = 25,000 = 20%
125,000
b) Division A is more profitability because its return on investment is greater than that of
division B.
 Return on investment formula is decomposed into two component ratios. These are
1. Profit margin
2. Asset turnover
1. Profit margin
Profit margin measure what percent of sale is converted to Operating income, Profit

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 margin is calculated as follows.
Profit margin= Operating income x 100%
Net sales
Example
consider the following data for ABC company
Operating income 45,000
Net sales 225,000
Required
compute the Profit margin for the company
Solution
Profit margin = Operating income = 45,000 =20%
Net sales 225,000
2. Asset turnover
Asset turnover measure the efficiency with which assets have been used to generate sales. Asset
turnover is the ratio of net sales to total assets i.e.
Asset turnover = Net salesx100%
Total assets
Example consider the following data for the company
Net sales =300,000
Total assets = 200,000

Required; compute Asset turnover for the company

Asset turnover = 300,000 = 1.5 times
200,000
The 1.5 times shows that a one birr invested in assets generated 1.5 birr sale.
The combination of profit margin and Asset turnover gives us return on investment. That is ROI
can be expressed as a product of the following two important factors:

ROI = Margin X Asset turnover

ROI = Operating income x Net sale

net sale total asset
Example
Consider the following data extracted from Nato company for the year ended December 31, 1994
Operating income = 50,000
Total assets = 200,000
Net sales = 250,000
Required : Compute
a) Profit margin
b)Asset turnover
c)Return on investment
solution

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a) Profit margin =Operating income = 50,000 =20%
Net sales 250,000

b)Asset turnover= Net sales= 250,000 =125%

Total asset200,000

c) ROI = Operating income = 50,000 =25%

total asset 200,000
alternatively, return on investment is calculated as follows:

ROI = profit margin x asset turn over

= 0.2 x 1.25
= 25%
The higher the ROI of a business segment, the greater the profit earned per dollar invested in the
segment’s operating assets.

Or ROI = Operating income

Average operating asset (fixed asset + current asset)

Any increase ROI must involve at least one of the following;

 Increase in sales
 Reduce operating expenses
 Reduce operating asset
The following data represent the result of operations for the most recent month.

Sales ---------------------------------------------$ 100,000

operating expense -------------------------------$ 90,000
operating income -----------------------------$ 10,000
average operating assets -------------------------$ 50,000

The ROI for the month is computed as follows

ROI = operating income x 100 %

average operating asset

= $ 10,000 = 0.2 = 20%

$ 50,000
Example 1: - increase sales without any increase in operating assets.
In addition to the above data, assume that x company is able to increase sales by 10% without
any increase in operating asset. The increase in sales will require additional operating expense.
Assume that the increase in operating expense will be 7.8% rather than 10%. The net operating
income would therefore be $ 12,980.
Sales (100,000 x 10%) + 100,000 = 110,000

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operating expense (90,000 x 7.8%) + 790,000 =97,020
net operating income ------- 12,980

In this case, the new ROI will be

ROI = net operating incomex100% = 12,980 = 25.96%
average operating asset 110,000

Example 2:- decrease operating expense with no change in sales or operating asset

In addition to the above data, assume that by improving business process, the manager of x
company is able to reduce operating expense by $ 1000 without any effect on sales or operating
assets. This reduction in operating expense will result in increased net operating income by $
1000 from $ 10,000 to $ 11,000. The new ROI will be;

ROI = operating income x 100%

average operating asset
= $ 11,000 = 22%
$ 50,000

Example 3:- decrease operating assets with no change in sales or operating expense.
In addition to the above data, assume that the manager of x company is able to reduce inventories
by $ 10,000. The reduction in inventories has no effect on sales or operating expense. The
reduction in inventories will reduce average operating assets by $ 10,000, from $ 50,000 down to
$ 40,000. The new ROI will be;

ROI = operating income x 100%

average operating asset
= $ 10,000 = 25%
$ 40,000
Reduce investment base means decrease idle cash, managing credit judiciously, determining
proper inventory level.

II. Residual income (RI)

Most manager agree that measuring return in relation to investment provide the ultimate test of
profitability. However, some managers favor emphasizing an absolute amount of income rather
than a percentage rate of return. They used residual income. This other approach measuring an
investment centers performance. Residual income is the operating income that an investment
center earns above the minimum return required on its operating asset, in equation

Residual income = operating income – (operating asset x minimum required rate of return)

Or RI = income – (minimum required rate of return x investment)

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Some company’s favor the RI measure because manager will concentrate on maximizing an absolute
amount, such as dollars of RI, rather than a percentage, such as ROI.

Example 1
Assume each hotel faces similar tasks. The RI for each hotel as hotel’s operating income minus
the required rate of return of 12% of the total asset of the hotel.
Hotel operating ___ required investment =RI residual return rate
income rate of return

San Francisco $ 240,000__$120,000 (12% x 1,000, 000) =$120, 000 120,000/1,000,000=12%

Chicago $300,000__ $240,000 (12% x2, 000,000) = $ 60,000 60,000/2,000,000=3%
New Orleans $510,000 _$360,000 (12% x 3,000,000) =$150, 000150, 000/3,000,000=5%

Example 2
Assume that the assembly division of furniture factory has operating income of $ 270,000 birr.
Its average assets for the year totaled 2 million. The top management assessed that the required
rate of return for factory is 10% of the total asset of the factory. Compute residual income for
assembly division

Solution:
Residual income = operating – (average operating x minimum required)
income asset rate of return

RI = 270,000 – (2,000,000 x 10%)

= 270,000 – 200,000
= 70,000

III. Economic value added (EVA)

Another measure of profitability for performance evaluation of investment centers is economic
value added. Economic value added (EVA)is after-tax operating income minus the total annual
cost of capital. If EVA is positive, the company is creating wealth. If it is negative, then the
company is destroying capital. Over the long term, only those companies creating capital, or
wealth, can survive. Many companies today are passionate believers in the power of EVA. When
EVA is used to adjust management compensation, it encourages managers to use existing and
new capital for maximum gain.
Calculating EVA
EVA is after-tax operating income minus the dollar cost of capital employed. The equation for
EVA is expressed as follows:
EVA = After-tax operating income – (Weighted average cost of capital× Total capital
employed).
The weighted average cost of capital is computed by taking the proportion of capital from each
source of financing and multiplying it by its cost.

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The difficulty faced by most companies is computing the cost of capital employed. Two-steps
are involved: (1) determine the weighted average cost of capital (a percentage figure)and (2)
determine the total dollar amount of capital employed.
To calculate the weighted average cost of capital, the company must identify all sources of
invested funds. Typical sources are borrowing and equity (stock issued). Any borrowed money
usually has an interest rate attached, and that rate can be adjusted for its tax deductibility. For
example, if a company has issued 10-year bonds at an annual interest rate of 8 percent and the
tax rate is 40 percent, then the after-tax cost of the bonds is 4.8 percent [0.08 – (0.4 × 0.08)].
Equity is handled differently. The cost of equity financing is the opportunity cost to investors. In
other words the cost of equity capital is the opportunity cost to investors of not investing their
capital in another investment that is similar in risk to their company.
The equation for EVA is expressed as follows:
EVA = After-tax operating income – (Weighted average cost of capital (WACC)× Total capital employed)
Example: Suppose that Furman, Inc. had after-tax operating income last year of $1,583,000.
Three sources of financing were used by the company: $2 million of mortgage bonds paying
8%interest, $3 million of unsecured bonds paying 10% interest, and $10 million in common
stock. Furman’s cost of equity capital is 12%.Furman, Inc., pays a marginal tax rate of 40%.
Required: A. Weighted average cost of capital (WACC)
B. The cost of capital
C. EVA
Solution :( A)
 The after-tax cost of the mortgage bonds is 0.048 i.e. [0.08 – (0.4 × 0.08)].
 The after-tax cost of the unsecured bonds is0.06 i.e. [0.10 – (0.4 × 0.10)]
 There are no tax adjustments for equity, so the cost of the common stock is 0.12.
Method I
WACC is calculated as follows:

Amount Percent× After-Tax Cost = Weighted Cost

Mortgage bonds $ 2,000,000 13.3% 0.048 0.006
Unsecured bonds 3,000,000 20 0.060 0.012
Common stock 10,000,000 66.7 0.120 0.080
Total $15,000,000
Weighted average cost of capital 0.098

Method II
WACC = Interest rate x amount of debt + interest rate x amount of equity

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 Amount of debt + Amount of equity
WACC = 2,000,000X0.048 + 3,000,000X0.06 +10,000,000 X 0.12 = 0.098
2,000,000 + 3,000,000 +10,000,000
(B). Cost of capital = WACCx Total capital employed
= 0.098 x15, 000,000= 1,470,000
(C). EVA = After-tax operating income --- Cost of capital
= $1,583,000 --- 1,470,000 = $ 113,000

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