Transfer Pricing & Utilizing Assets EmployedChapters 5 & 6,Management Control Systems, 12th Ed.,Anthony and Govindarajan

Transfer Pricing

The pricing system for the transfer of goods or services between two profit centers within the same organization.Can also apply to services provided by corporate staff units.

Objectives of a Transfer Price

Provide relevant info to provide for optimum company profitsInduce goal congruent decisionsMeasure economic performanceSimple and easy to understand

Fundamental Principle

The fundamental principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors. [Text, p. 202]

Various Situations

Market PriceConstrainedLimited MarketsExcess / Shortage of Industry CapacityCost-BasedCost BasisProfit Markup

Various Situations

Upstream Fixed Costs and ProfitsAgreement (meet periodically and determine)Two-Step (combine variable & fixed costs)Profit SharingTwo Sets of Prices (outside sales price & standard cost)

Corporate Services

Control over Service ProvidedOptional Use of that ServiceSimplicity of Pricing

Transfer Price Administration

NegotiationArbitration / Conflict ResolutionProduct Classification

Measuring and Controlling Assets Employed

The terms profit center and investment center are often used interchangeably Profit center measured on profit in relation to a profit targetInvestment center measured on return on the assets used to earn profit

Assets

CurrentCashReceivablesInventoriesPlant, Property, & EquipmentLeased IdleIntangible

Definitions

Return of Investment (ROI)A Ratio (Income Statement & Balance Sheet)Income / Assets EmployedEconomic Value Added (EVA)A Dollar AmountNet Operating Profit Capital Charge

Why Use EVA?

Profit objectives are consistentInvestments yielding above cost of capital are attractiveDifferent interest rates may be used for different investmentsCauses the creation and growth of added value for the corporation

EVA Calculation

EVA = Net Operating Profit Capital ChargeWhereCapital Charge = Cost of Capital * Capital EmployedCost of Capital is Weighted AverageOR

EVA = Capital Charge * (ROI Cost of Capital)