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258 8 Pricing
LEARNING *
OBJECTIVE
6
APPENDIX 8B: Explain issues involved in transferring goods
between divisions in different countries.
Companies must pay income tax in the country where they generate the income.
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. They accomplish this by adjusting the transfer prices they
use on internal transfers between divisions located in different countries. They
allocate more contribution margin to the division in the low-tax-rate country,
and allocate less to the division in the high-tax-rate country.
To illustrate, suppose that Alberta’s Boot Division is located in a country
with a corporate tax rate of 10%, and the Sole Division is located in a country
with a tax rate of 30%. Illustration 8B-1 compares the after-tax contribution
margin to the company using a transfer price of $18 versus a transfer price
of $11.
Illustration 8B-1
After-tax contribution margin
per unit under alternative
transfer prices
At $18 Transfer Price
Boot Division
Sole Division
Selling price of boots
Variable cost of boot
(not including sole)
Cost of sole purchased internally
$90.00
35.00
Selling price of sole
Variable cost per sole
$18.00
11.00
Before-tax contribution margin
Tax at 10%
37.00
3.70
Before-tax contribution margin
Tax at 30%
7.00
2.10
After-tax contribution margin
$33.30
After-tax contribution margin
$ 4.90
18.00
Before-tax total contribution margin per unit to company 5 $37 1 $7 5 $44
After-tax total contribution margin per unit to company 5 $33.30 1 $4.90 5 $38.20
At $11 Transfer Price
Boot Division
Sole Division
Selling price of boots
Variable cost of boot
(not including sole)
Cost of sole purchased internally
$90.00
35.00
Selling price of sole
Variable cost per sole
$11.00
11.00
Before-tax contribution margin
Tax at 10%
44.00
4.40
Before-tax contribution margin
Tax at 30%
0.00
0.00
After-tax contribution margin
$39.60
After-tax contribution margin
$ 0.00
11.00
Before-tax total contribution margin per unit to company 5 $44 1 $0 5 $44
After-tax total contribution margin per unit to company 5 $39.60 1 $0 5 $39.60
Note that the before-tax total contribution margin to Alberta Company is $44
regardless of whether the transfer price is $18 or $11. However, the after-tax total
contribution margin to Alberta Company is $38.20 using the $18 transfer price
and $39.60 using the $11 transfer price. The reason: When Alberta uses the $11
transfer price, more of the contribution margin is attributed to the division that
is in the country with the lower tax rate, so it pays $1.40 less per shoe in taxes
[($3.70 1 $2.10) 2 $4.40].
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Review and Practice
259
As this analysis shows, Alberta Company would be better off using the $11
transfer price. However, this presents some concerns. First, the Sole Division
manager will not be happy with an $11 transfer price. This price may lead to
unfair evaluations of the Sole Division’s manager. Second, the company must ask
whether it is legal and ethical to use an $11 transfer price when the market price
clearly is higher than that.
Additional consideration of international transfer pricing is discussed in
advanced accounting courses.
REVIEW AND PRACTICE
LEARNING OBJECTIVES REVIEW
11 Compute a target cost when the market determines a
product price. To compute a target cost, the company
determines its target selling price. Once the target
selling price is set, it determines its target cost by
setting a desired profit. The difference between the
target price and desired profit is the target cost of the
product.
cost-based system is its simplicity. A market-based
transfer price is based on existing competing market
prices and services. A market-based system is
often considered the best approach because it is
objective and generally provides the proper economic
incentives.
* 5 Determine prices using absorption-cost pricing and
variable-cost pricing. Absorption-cost pricing uses
total manufacturing cost as the cost base and provides for selling and administrative costs plus the
target ROI through the markup. The target selling
price is computed as: Manufacturing cost per unit 1
(Markup percentage 3 Manufacturing cost per unit).
Variable-cost pricing uses all of the variable costs,
including selling and administrative costs, as the cost
base and provides for fixed costs and target ROI
through the markup. The target selling price is computed as: Variable cost per unit 1 (Markup percentage 3 Variable cost per unit).
2
Compute a target selling price using cost-plus pricing.
Cost-plus pricing involves establishing a cost base
and adding to this cost base a markup to determine a
target selling price. The cost-plus pricing formula is
expressed as follows: Target selling price 5 Cost 1
(Markup percentage 3 Cost).
3
Use time-and-material pricing to determine the cost
of services provided. Under time-and-material pricing, two pricing rates are set—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
* 6 Explain issues involved in transferring goods between
charge for related overhead costs.
divisions in different countries. Companies must
pay income tax in the country where they generate
Determine a transfer price using the negotiated,
the income. In order to maximize income and minicost-based, and market-based approaches. The
mize income tax, many companies prefer to report
negotiated price is determined through agreement of
more income in countries with low tax rates, and less
division managers. Under a cost-based approach, the
income in countries with high tax rates. This is accomtransfer price may be based on variable cost alone or
plished by adjusting the transfer prices they use on
on variable costs plus fixed costs. Companies may
internal transfers between divisions located in different
add a markup to these numbers. The cost-based
countries.
approach often leads to poor performance evaluations and purchasing decisions. The advantage of the
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