Transfer Pricing Technique

7/28/2019 Transfer Pricing Technique

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Transfer Pricing/Strategy

Case 18-2

Presented by: Group 3

Nidhi Jain, Ajay Aggarwal,

Thomas Giap, Qingwei Meng


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Transfer Pricing

Definition Determination of exchange price when different business

units within a firm exchange the products and services

When it is important

Firm with vertical integration, having different value-creatingactivities in the value chain

Objective

To motivate managers

To provide appropriate incentive for managers

To provide basis for fairly rewarding managers Minimize taxes locally as well as internationally

To develop strategic partnership


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Transfer Pricing Methods

Variable Cost Method

Transfer price = variable cost of selling unit + markup

Full cost Method

Transfer price = Variable Cost + allocated fixed cost Market Price Method

Transfer price = current price for the selling units in the

market

Negotiated price method


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Choosing the Right Transfer Price

Is there an outside supplier?

Is the sellers variable cost less than the

market price?

Is the selling unit operating at full capacity?


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Cole Division Assumptions

Cole Division will buy components only from

Bayside division I.e. there is no outside

supplier

Cole can sell inside or outside the firm Cole division is at full capacity


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Robert Products Inc.

INTERNAL TO THE FIRM EXTERNAL

FOREIGN

Diamond

Wales

Company

London

CompanyPrice = $1,500

Bayside

Cole


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Cole Division

Diamond division

Cole Division

price= $1,100 or

$1,500

Further processing variable

cost- $500

Wales company

Further processing variable

cost- $400

?price $1,250

Bayside division3,500 Units, var cost

$250 per unit

Price =$600

3,000 Units, var cost

$300 per unit

Internal to the firm External to the firm

Price = $500


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Diamond Division

Diamond division

Diamond Division

3,000 Units

Further processing

variable cost- $500

Bayside division

Price =$600

Variable cost - $300

Cole Division London Company

London company

3,000 Units,

price- $1,500

Price= $400

Variable cost-$200


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Cole Division

If there is an outside supply ----Yes.

Is the sellers variable costs < outside price?Yes.

Does seller have excess capacity? No.

If contribution from outside purchase > contributionfrom inside purchase . . .

Decision to Transfer: Sell outside.


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Transfer Pricing

Cole Division Bayside TotalSales ( $1,500, $600) $1,500 $600 $2,100

Less: Variable Costs

component cost # $600 $600

processing cost # $500 $300 $800Contribution Margin/Unit $400 $300 $700

Total Contribution Margin $1,200,000 $900,000 $2,100,000

Option -1

Cole Division Sells to Diamond Division

Contribution Income Statement -3,000 units


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Cole

Division

Bayside

supplying to

Cole

Bayside

supplying to

London Total

Sales ( $1250, $500, $400) $1,250 $500 $343

Less: Variable Costs $500

component cost ## $500 $821

processing cost ## $400 $250 $171 $771Contribution Margin/Unit $350 $250 $171 $771

Total Contribution Margin $1,225,000 $875,000 $600,000 $2,700,000

Contribution Income Statement -3,500 units

Cole division Sells to Outside Firm ( Wales)Option -2

Transfer Pricing

The firm benefits more from Option 2.


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Strategic Factors

International Transfer Pricing Consideration

Tax Rate- minimize taxes locally as well internationally

Exchange Rate

Custom Charges

Risk of expropriation Currency Restriction

Strategic relationship

Assist bayside division to grow

Gain entrance in the new country Suppliers quality or name


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Transfer Pricing with ABC


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Q1. Why did Teva introduce transfer

pricing Teva, a multinational pharmaceutical company, solved its transfer pricing

problems by using activity-based costing

Teva reorganized its pharmaceutical operations into 1 operation division (with 4

manufacturing plants) and 3 marketing divisions

Marketing divisions are organized into the US marketing and the local market,

and the rest of the world Responsible for decisions about sales, product mix, pricing and customer

relationships

Marketing were evaluated on sales, not profit

Manufacturing plants were measured how meeting expense budgets and

delivered the right orders on time Cost system emphasized variable costs: materials expenses and direct labor. All

other costs were considered fixed

Decided to introduce transfer pricing system that would enhance profit

consciousness and improve coordination between operations and

marketing


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Q2. What Everyone Wanted

Senior Management

1. System that encourages decisions consistent with long-run

profitability

Encourage actions that benefits the overall companys

profitability

2. Allows managers to distinguish costs relevant for short-run

decisions

3. Transfer prices could be used to support decisions in both

marketing and operating divisions, including:

Marketing Operations- Product Mix - Inventory levels- New Product Introduction - Batch sizes- Product deletion - Process Improvements- Pricing - Capacity management

- Outsourcing: make vs. buy


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Division Managers

1. Transfer prices would report the financial performance of their divisions

fairly

2. Managers could influence the reported performance of their divisions by

making business decisions within their scope of authority

Performance should reflect changes in product mix, improved

efficiency, investment in new equipment, and organizational

changes

3. Decisions made by managers of marketing divisions would reflect both

sales revenue and associated expenses incurred in the operationsdivision

4. The system must anticipate that division managers would examine the

method and take actions that maximized the reported performance of

their divisions


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Financial Staff

1. Credible and reliable information for decision making at all levels of the

organization without excessive arguments and controversy

2. System that is clear, easy to explain, and easy to use

Updates should be easy

Components of the transfer price calculation should promote good

understanding of the underlying factors driving costs

3. System would be used for internal charging of costs from the operations

division to the marketing divisions


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Q3. Why Traditional Transfer Pricing

Method not work Variable Cost Method

Covering only ingredients and packaging materials which was inadequate for theirpurposes

Marketing divisions would report extremely high profits because they were beingcharged for materials only

Operations divisions would get credit only for expenses of purchased materials

No motivation to control labor or other fixed expenses Marginal cost transfer price would give the marketing divisions no incentive to shift

their source of supply

Measuring profits as price less materials cost would continue to allow marketing

and sales decisions to be make without regard to their implications for production

capacity and long-run costs and overall company profitability

Full cost Method Overhead did not capture the actual cost structure in Tevas plant

Market Price Method

No market existed for manufactured and packaged products that had not beendistributed or marketed to customers

Negotiated price method

Would lead to endless arguments


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Q3. Why did ABC work?

1. First decided to implement ABC in its largest production plant

2. A multidisciplinary project team develop an activity dictionary, drive factory costs to

activities, identify cost drivers for each activity, collect data, and calculate ABC based

product costs

3. Originally the ABC models were retrospective

Calculating the activities costs, activity cost driver rates, and product costsfor the prior year

4. End of 1993, senior management wanted to use ABC to calculate transfer prices for

the coming year

Teva built its ABC production cost model for 1994 using data from the first three

quarters 19935. Group decided to use the forecasted costs based on budgeted expense data,

forecasted volumes and mix of sales, projected process utilization and efficiencies to

calculate the transfer price


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Q4. Using ABC costs for Transfer

Pricing

Manufacturing Plants

Marketing Division

Unit CostsBatch

Costs

Product

Specific

Plant

Level

Cost Pools

Charges based on

actual quantities of

each individualproducts acquire

Materials and labor

Charged for actual

number of production

and packagingbatches of each

product order

Charges based on

budgeted numbers

No individual

product is sold to

more than one

marketing division

Based on the

budgeted use of the

capacity of the 4manufacturing

facilities


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Q4. The ABC Transfer Price Model

Structure ABC hierarchical structure of unit, batch, product sustaining and plant-level costs

1. Unit Level Costs direct expenses associated with producing individual product

units such as tablets, capsules, and ampoules

Includes cost of raw materials, packaging materials, and direct wages paid

to production workers

2. Batch-level costs expenses of resources used for each production orpackaging batch.

Costs of preparation, setup, cleaning, quality control, lab testing, and

computer, packaging and production management

Lot sizes for production are predetermined based on the capacity of the

containers in the production line3. Product sustaining costs expenses incurred in registering the products,

making changes to a products production processes, and designing the package

4. Plant-level costs cost of maintaining the capacity of production lines including

depreciation, cost of safety inspections, insurance, and general expenses


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Q4. Using ABC costs for Transfer

Pricing Prices are set for the coming year based on budgeted data

Calculates standard activity cost driver rates for each activity

1. Enables product costs to be calculated in a predictable manner throughout the

year

2. Eliminates fluctuations in product costs caused by variations in actual spending,

resource usage, and activity levels

3. Activity cost driver rates are based on the practical capacity of each of the four

plants

Rates reflect the underlying efficiency and productivity of the plants without

being influenced by fluctuations in forecasted or actual usage

Transfer prices are calculated in two different procedures

1. Assigns unit and batch-level costs

2. Product-specific and plant-level costs


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Q5. Ongoing benefits from ABC

Transfer Pricing System Highlighted unused capacity shows where production can be expanded without

spending additional money

Capacity released by ceasing production of unprofitable products

Investment decision for a new production line incorporates the cost and assignment of

responsibility for the unused capacity in the early periods provides valuable realism

to the demand forecasts provided by the marketing division

Motivates cost reduction and production efficiencies in the manufacturing plant

Identify ways to reduce unit and batch-level expenses

Conduct common searches for lower-cost, more reliable, higher-quality suppliers

to reduce variable materials costs

Helps to determine which manufacturing facility is appropriate for different types ofproducts

Figure 1 Structure of Costs in Plants A and B

Plant A Plant BUnit Based Cost 42% 45%Batched Based Cost 32% 30%Product Based Cost 20% 23%

Plant Based Cost 6% 2%

Plant A has a relatively inflexible (high capital

intensive) cost structure with high percentage of plant-

level costs and low percentage of unit cost plant most

appropriate for high-volume production

Plant B is much more flexible and is appropriate for

small batch sizes and test runs of newly introducedproducts


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Q5. Benefits of ABC - Unused Capacity

Unused capacity occurs in two ways

1. Declines in demand for products manufactured on an existing line

2. Partial usage when a new production line is added because existing production

lines cannot produce the additional quantities requested by one of the marketing

divisions

Marketing divisions are charged a lump-sum for the cost of maintaining the unusedproduction capacity in an existing line

Fosters a send of responsibility among marketing managers

Increments in production capacity or manufacturing technology are paid for by the

initiating marketing division

Bears the costs of all additional resources supplied

If the increment begins to be used by another marketing division then each

marketing division would be charged based on its percentage of capacity used.


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Q5. Benefits to the Marketing Division

Integrated budget process lets marketing managers plan their product mix withknowledge of the cost impact of their decisions

Proposed increases in variety and complexity will be charged accordingly based

on the increased demands on manufacturing facilities

Marketing managers are given the flexible to decide when to accept small order

from a customer or how much of a discount to grant for large orders based on

cost details

Marketing mangers can monitor closely the costs incurred in the manufacturing

plants (fixed costs) because of separating out the unit and batch-level costs

Responsibility for the fixed costs increment is clearly assignable to the

requesting division

Marketing managers can distinguish between products that cover all manufacturingcosts versus those that cover only the unit and batch-level expenses

Able to incorporate information about available capacity when they make decisions

about pricing, product mix, and product introduction

Led to decisions to sell 30 low-volume products to another company so Teva was

able to freed-up capacity to handled production of new products or existingprofitable products


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Q5. The Best News: Harmony is

Growing Unexpected benefit of activity-based transfer price system is the ability to measure

profit performance under changing organizational structures

Forecast potential impact of newly created profit centers by understanding cost

behaviors at the activity and product level

Enables executives to measure profit performance across organizational cost and

profit centers boundaries

ABC are not the primary information used for short-term operational decision making

Current bottlenecks and lead-time considerations are the focus

ABC provides guidance and insights about where to look

ABC-based transfer prices has lead to a dramatic reduction in conflicts among

marketing and manufacturing managers Managers have confidence in the production cost economics reported by the

transfer price system

Table 1. Pain Reliever


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Table 1.

10 Tablets, 250 mg.

Annual Sales 1996 - $2.1 Million

ABC Cost per Package

Materials use $1.50Production costs $2.10

Total $3.60(Traditional production costs per package were only$1.50, 40% difference)

Production Cost Analysis

Resources

Salaries $0.86Energy $0.27Utilities $0.34

Depreciation $0.41Administrative $0.22Total $2.10

Main Activities

Storage $0.25Manufacturing $0.61Packaging $0.71Q.A. $0.42

Logistics $0.11Total $2.10

Cost Drivers

Number of materials $0.55Batches $0.24Labor hours $0.71

Machine hours $0.47Samples $0.13

Total $2.10


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Table 2Batch Level Transfer Price

Cost of production for a packaging batch can vary among differentproducts and among different plants

Batch costs assigned to a particular order include two

components

1. A pro-rata share of the batch cost of production setup

2. The full batch cost of the packaging setup

Produce a full batch of 6,000 bottles of 100 ml syrup for a large order from a customer in a local market

[$300/6,000] + [$500/6,000] = $.05 + $.083 = $1.33/bottle

Produce a small order of 1,000 bottles of 100 ml syrup, packed in special boxes, for a special tender in S. America

[$300/6,000] + [$500/1,000] = $.05 + $.50 = $0.55/bottle

Produce a full batch of 12,000 bottles of 50 ml syrup for a large oder from a customer in the local market

[$300/12,000] + [$500/12,000] = $.025 + $.043 = $0.67/bottle

mixing packing

mixing packing

mixing packing


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Table 3. Monthly DebitMay 1995

From Plant A to Local Market Division

Unit Based Batched Based Total

Quantity Material Costs Costs Costs *

Product Produced (per Package) (per Package) (per Package) (per Package) Total Debit **

Pain Reliever 1,000,000 $2.10 $0.22 $0.41 $2.73 $2,730,00020 tablets, 500mg.

Pain Reliever 1,200,000 $1.60 $0.20 $0.32 $2.12 $2,544,00030 Capsules

Syrup 200 cc. 200,000 $0.81 $0.43 $0.11 $1.35 $270,000l l

l l

l l

Total $15,100,200

* Total costs = material + unit based costs = batch based costs** Total debit = total costs per package x quantity produced


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Table 4. Annual Debit - 1995

From Plant A to Local Market Division

Annual Product Plant Based TotalBudgeted Based Costs Costs Costs *

Product Quantity (per Package) (per Package) (per Package) Total Debit **

Pain Reliever 12,000,000 $0.10 $0.21 $0.31 $3,720,00020 tablets, 500mg.

Pain Reliever 20,000,000 $0.12 $0.20 $0.32 $6,400,00030 Capsules

Syrup 200 cc. 3,500,000 $0.14 $0.12 $0.26 $910,000l l

l l

l l

Cost of used capacity $141,900,000Cost of unused capacity $1,300,000Total $143,200,000

* Total costs = product based costs + plant based costs** Total debit = total costs per package x annual budgeted quantity


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Table 5. 10 Leading Products

Segment A: 1995

Sales revenue $50

Marketing Expenses

USA Lemmon division $10Local market division $9Other export division $0Total $19

Manufacturing Expenses

Plant A $11

Plant B $0Plant C $9Plant D $0Total $20

Total Expenses $39

Profit $11

Shows the profitability of

a significant product family

whose individual products

are manufactured indifferent plants and are

sold by more than one

marketing division

Transfer Pricing Technique

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