Transfer PricingAppendix 12A

Key Concepts/DefinitionsA transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company.

Three Primary ApproachesThere are three primary approaches to setting transfer prices: Negotiated transfer prices;Transfers at the cost to the selling division; andTransfers at market price.

Negotiated Transfer PricesA negotiated transfer price results from discussions between the selling and buying divisions.Advantages of negotiated transfer prices:They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization.The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

Grocery StorehouseAssume the information as shown with respect to West Coast Plantations and Grocery Mart (both companies are owned by Grocery Storehouse).

Sheet1

Pipe Products

9-Inch12-Inch18-InchTotal

Warehouse sq. ft.1,0004,0005,00010,000

Lease price per sq. ft.$4$4$4$4

Total lease cost$4,000$16,000$20,000$40,000

Acquisition cost

Less: Accumulated depreciation

Net book value

Residual income=Net operating income-Average operating assetsMinimum required rate of return

Sheet2

West Coast Plantations:

Naval orange harvest capactiy per month10,000crates

Variable cost per crate of naval oranges$10per crate

Fixed costs per month$100,000

Selling price of navel oranges on the outside market$25per crate

Grocery Mart:

Purchase price of current naval oranges$20per crate

Monthly sales of naval oranges1,000crates

Sheet3

Grocery StorehouseWest Coast Plantation can provide supply of oranges to Grocery Mart (a unit of Grocery Storehouse)

West Coast Plantation selling divisionGrocery Mart buying division

Grocery Storehouse An ExampleThe buying divisions (Grocery Mart) highest acceptable transfer price is calculated as:Lets calculate the lowest and highest acceptable transfer prices under three scenarios.

Sheet1

Pipe Products

9-Inch12-Inch18-InchTotal

Warehouse sq. ft.1,0004,0005,00010,000

Lease price per sq. ft.$4$4$4$4

Total lease cost$4,000$16,000$20,000$40,000

Acquisition cost

Less: Accumulated depreciation

Net book value

Residual income=Net operating income-Average operating assetsMinimum required rate of return

Sheet2

Imperial Beverages:

Ginger beer production capactiy per month10,000barrels

Variable cost per barrel of ginger beer8per barrel

Fixed costs per month70,000

Selling price of Imperial Beverages ginger beer on the outside market20per barrel

Pizza Maven:

Purchase price of regular brand of ginger beer18per barrel

Monthly comsumption of ginger beer2,000barrels

Transfer PriceVariable cost+Total contribution margin on lost salesTransfer PriceCost of buying from outside supplier

per unitNumber of units transferred

Sheet3

Grocery Storehouse An ExampleIf West Coast Plantations has sufficient idle capacity (3,000 crates) to satisfy Grocery Marts demands (1,000 crates), without sacrificing sales to other customers, then the lowest and highest possible transfer prices are computed as follows:

Grocery Storehouse An ExampleIf West Coast Plantations has no idle capacity (0 crates) and must sacrifice other customer orders (1,000 crates) to meet Grocery Marts demands (1,000 crates), then the lowest and highest possible transfer prices are computed as follows:

Grocery Storehouse An ExampleIf West Coast Plantations has some idle capacity (750 crates) and must sacrifice other customer orders (250 crates) to meet Grocery Marts demands (1,000 crates), then the lowest and highest possible transfer prices are computed as follows:

Transfers at the Cost to the Selling DivisionMany companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division.Drawbacks of this approach include:Using full cost as a transfer price can lead to suboptimization.The selling division will never show a profit on any internal transfer. Cost-based transfer prices do not provide incentives to control costs.

Transfers at Market PriceA market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity.A market price approach does not work well when the selling division has idle capacity.

Divisional Autonomy and SuboptimizationThe principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally, even if this may occasionally result in suboptimal decisions. This way top management allows subordinates to control their own destiny.

Ex 12A-1 Case AAssume that there is a $3 per unit in variable selling costs that can be avoided on intercompany sales. What is the range of transfer prices?

Ex 12A-1 Case BAssume that there is will be no savings in variable selling costs on intercompany sales. What is the range of transfer prices?

Ex 12A-2Sako Companys Audio Division produces a speaker that is used by manufacturers of various audio products. Sales and cost data on the speaker follow:Sako Companyhas a Hi-Fi Division that could use this speaker in one of its products. The Hi Fi Division will need 5000 speakers per year. It has received a quote of $57 per speaker form another manufacturer. Sake Company evaluates division managers on the basis of divisional profits.

Ex 12A-3Division A manufactues electronic circuit boards. The boards can be sold either to division B of the same company or to outside customers. Last year, the following activity occurred in Division A.Sales to Division B were at the same price as sales to outside customers. The circuit boards purchased by Division B were used in an electronic instrument manufactured by that division. Division B incurred $100 in additional variable cost per instrument and then sold the instruments for $300 each.

Ex 12A-3Prepare an income statement for Division A, Division B and the company as a whole.Assume that division As capacity is 20,000 circuit boards. Next year, Division B wants to purchase 5,000 circuit boards from Division A rather than 4,000. (Circuit boards of this type is not available from outside sources) Should the company sell to Division B or sell them to outside customers?

END OF COVERAGE OF QUIZ 4

Financial Statement Analysis

Ratio Analysis The Common Stockholder The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders equities.

Schedule

NORTON CORPORATION

2008

Number of common shares outstanding17,000

Beginning of year17,000

End of year27,400

Net income53,69057,500

Stockholders' equity

Beginning of year180,000216,000

End of year234,390220,000

Dividends per share28

Dec. 31 market price per share20

Interest expense7,300

Total assets

Beginning of year$300,000

End of year$346,390

Earnings Per ShareWhenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.Earnings form the basis for dividend payments and future increases in the value of shares of stock.

Earnings Per ShareThis measure indicates how muchincome was earned for each share of common stock outstanding.

Price-Earnings RatioA higher price-earnings ratio means that investors are willing to pay a premium for a companys stock because of optimistic future growth prospects.

Dividend Payout RatioThis ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large (small).

Dividend Yield RatioThis ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

Return on Total AssetsAdding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.

Return on Common Stockholders EquityThis measure indicates how well the company used the owners investments to earn income.

Financial Leverage Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors.

Quick Check Which of the following statements is true?a. Negative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets.b. Positive financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets.c. Financial leverage is the expression of several years financial data in percentage form in terms of a base year.

Which of the following statements is true?a. Negative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets.b. Positive financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets.c. Financial leverage is the expression of several years financial data in percentage form in terms of a base year.Quick Check

Book Value Per ShareThis ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off.

Book Value Per ShareNotice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.

Learning Objective 3Compute and interpret financial ratios that would be useful to a short-term creditor.

Ratio Analysis The ShortTerm Creditor Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the companys cash flows and working capital.

Sheet1

NORTON CORPORATION

2008December 31, 19X4

Cash$30,000$20,000

Accounts receivable, net17,000

Beginning of year17,000

End of year20,000

Inventory10,000

Beginning of year10,000

End of year12,000

Total current assets$65,000$47,000

Total current liabilities42,00040,000

Sales on account$494,000

Cost of goods sold$140,000

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet7

Sheet8

Sheet9

Sheet10

Sheet11

Sheet12

Sheet13

Sheet14

Sheet15

Sheet16

Working CapitalThe excess of current assets over current liabilities is known as working capital.Working capital is not free. It must be financed with long-term debt and equity.

Working Capital

Sheet1

December 31, 2008

Current assets$65,000

Current liabilities(42,000)

Working capital$23,000

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet7

Sheet8

Sheet9

Sheet10

Sheet11

Sheet12

Sheet13

Sheet14

Sheet15

Sheet16

Current RatioThe current ratio measures a companys short-term debt paying ability.A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.

Current Ratio

Acid-Test (Quick) RatioQuick assets include Cash,Marketable Securities, Accounts Receivable, and current Notes Receivable. This ratio measures a companys ability to meet obligations without having to liquidate inventory.

Accounts Receivable TurnoverThis ratio measures how many times a company converts its receivables into cash each year.

Average Collection PeriodThis ratio measures, on average, how many days it takes to collect an account receivable.

Inventory TurnoverThis ratio measures how many times a companys inventory has been sold and replaced during the year.If a companys inventory turnover Is less than its industry average, it either has excessive inventory or the wrong types of inventory.

Inventory Turnover

Average Sale PeriodThis ratio measures how many days, on average, it takes to sell the entire inventory.

Learning Objective 4Compute and interpret financial ratios that would be useful to a long-term creditor.

Ratio Analysis The LongTerm Creditor Long-term creditors are concerned with a companys ability to repay its loans over the long-run.This is also referred to as net operating income.

Sheet1

NORTON CORPORATION

2008December 31, 19X4

Earnings before interest expense and income taxes$84,000$220,000

Interest expense$7,300

Total stockholders' equity$234,390

Total liabilities112,000

220,000

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet7

Sheet8

Sheet9

Sheet10

Sheet11

Sheet12

Sheet13

Sheet14

Sheet15

Sheet16

Times Interest Earned RatioThis is the most common measure of a companys ability to provide protection for its long-term creditors. A ratio of less than 1.0 is inadequate.Times Interest EarnedEarnings before Interest Expense and Income TaxesInterest Expense=

Debt-to-Equity RatioThis ratio indicates the relative proportions of debt to equity on a companys balance sheet.Stockholders like a lot of debt if the company can take advantage of positive financial leverage.Creditors prefer less debt and more equity because equity represents a buffer of protection.

Debt-to-Equity Ratio

Exercises Exercise: 16-7, 16-8, 16-9 and 16-10.

Appendix 12A: Transfer Pricing.A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. While domestic transfer prices have no direct effect on the entire companys reported profit, they can have a dramatic effect on the reported profitability of a division.The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. Suboptimization occurs when managers do not act in the best interests of the overall company or even their own divisions.There are three primary approaches to setting transfer prices, namely negotiated transfer prices, transfers at the cost to the selling division, and transfers at market price.

A negotiated transfer price results from discussions between the selling and buying divisions. Negotiated transfer prices have two advantages.

First, they preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

Second, the range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase. The lower limit is determined by the selling division. The upper limit is determined by the buying division.

Assume the information as shown with respect to West Coast Plantations and Grocery Mart (both companies are owned by Grocery Storehouse).

Assume the information as shown with respect to West Coast Plantations and Grocery Mart (both companies are owned by Grocery Storehouse).

The selling divisions (West Coast Plantations) lowest acceptable transfer price is calculated as shown.

The buying divisions (Grocery Mart) highest acceptable transfer price is calculated as shown.

If Grocery Mart had no outside supplier for naval oranges, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the naval oranges, net of its own expenses.

Lets calculate the lowest and highest acceptable transfer prices under three scenarios.

Part IIf West Coast Plantations has sufficient idle capacity (3,000 crates) to satisfy Grocery Marts demands (1,000 crates) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as follows.

Part IIThe lowest acceptable transfer price, as determined by the seller, is $10.

Part IIIThe highest acceptable transfer price, as determined by the buyer, is $20. Therefore, the range of acceptable transfer prices is $10 to $20.

Part IIf West Coast Plantations has no idle capacity and must sacrifice other customer orders (1,000 crates) to meet the demands of Grocery Mart (1,000 crates), then the lowest and highest possible transfer prices will be computed as follows.

Part IIThe lowest acceptable transfer price, as determined by the seller, is $25.

Part IIIThe highest acceptable transfer price, as determined by the buyer, is $20. Therefore, there is no range of acceptable transfer prices. This is a desirable outcome for Grocery Storehouse because it would be illogical to give up sales of $25 to save costs of $20. Part IIf West Coast Plantations has some idle capacity (500 crates) and must sacrifice other customer orders (500 crates) to meet the demands of Grocery Mart (1,000 crates), then the lowest and highest possible transfer prices will be computed as follows.

Part IIThe lowest acceptable transfer price, as determined by the seller, is $17.50.

Part IIIThe highest acceptable transfer price, as determined by the buyer, is $20. Therefore, the range of acceptable transfer prices is $17.50 to $20.00.

Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. The drawbacks of this approach include:Using full cost as a transfer price can lead to suboptimization because it does not distinguish between variable costs, which may be relevant to the transfer pricing decision, and fixed costs, which may be irrelevant.

If cost is used as the transfer price, the selling division will never show a profit on any internal transfer. The only division that shows a profit is the division that makes the final sale to an outside party.

Cost-based transfer prices do not provide incentives to control costs. If the actual costs of one division are passed on to the next, there is little incentive for anyone to work on reducing costs. A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.It works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity.With no idle capacity the real cost of the transfer from the companys perspective is the opportunity cost of the lost revenue on the outside sale.

It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole. The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally. While subordinate managers may occasionally make suboptimal decisions, top managers should allow their subordinates to control their own destiny even to the extent of granting subordinate managers the right to make mistakes. The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders equities. The information shown for Norton Corporation will be used to calculate ratios of interest to common stockholders. 16-*Earnings per share is computed as shown.

The average number of common shares outstanding is computed by adding the shares outstanding at the beginning of the year to the shares outstanding at the end of the year and dividing by two.

Investors are interested in this ratio because earnings form the basis for dividend payments and future increases in the value of shares of stock. 16-*Norton Corporations earnings per share is $2.42. This measure indicates how much income was earned for each share of common stock outstanding.16-*The price-earnings ratio is computed as shown.

A higher price-earnings ratio means that investors are willing to pay a premium for a companys stock because of its optimistic future growth prospects. Norton Corporations price-earnings ratio is 8.26 times. 16-*The dividend payout ratio is computed as shown.

Investors who seek market price growth would like this ratio to be small, whereas investors who seek dividends prefer it to be large.

Norton Corporations dividend payout ratio is 82.6 percent. 16-*The dividend yield ratio is computed as shown.

This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price.

Norton Corporations dividend yield ratio is 10 percent. 16-*The return on total assets is computed as shown.

Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.

Norton Corporations return on assets is 18.19 percent.

16-*The return on common stockholders equity is computed as shown.

This measure indicates how well the company used the owners investments to earn net income.

Norton Corporations return on common stockholders equity is 25.91 percent for the most recent year. 16-*Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors.

Positive financial leverage exists if the rate of return on the companys assets exceeds the rate of return the company pays its creditors. In this case, having some debt in a companys capital structure can benefit its shareholders.

Negative financial leverage exists if the rate of return on the companys assets is less than the rate of return the company pays its creditors. In this case, the common stockholder suffers by having debt in the capital structure. 16-*Which of the following statements is true?

16-*The answer is A. Negative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets.

16-*The book value per share is computed as shown.

It measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off. This measure is based entirely on historical cost.

Norton Corporations book value per share is $8.55. 16-*The book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost. 16-*Learning objective number 3 is to compute and interpret financial ratios that would be useful to a short-term creditor.

16-*Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the companys cash flows and on its working capital. The information shown for Norton Corporation will be used to calculate ratios of interest to short-term creditors. 16-*The excess of current assets over current liabilities is known as working capital.

Working capital is not free. It must be financed with long-term debt and equity. Therefore, managers often seek to minimize working capital.

A large and growing working capital balance may not be a good sign. For example, it could be the result of unwarranted growth in inventories.

16-*Norton Corporations working capital of $23,000 is calculated as current assets of $65,000 minus current liabilities of $42,000. 16-*The current ratio is computed as shown.

It measures a companys short-term debt paying ability.

It must be interpreted with care. For example, a declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories or other stagnant current assets.

16-*Norton Corporations current ratio of 1.55 is calculated as shown.

16-*The acid-test ratio is computed as shown.

It is a more rigorous measure of short-term debt paying ability because it only includes cash, marketable securities, accounts receivable, and current notes receivable.

It measures a companys ability to meet its obligations without having to liquidate its inventory.

Norton Corporations acid-test ratio is 1.19. Each dollar of liabilities should be backed by at least one dollar of quick assets. Norton satisfies this condition.

16-*The accounts receivable turnover is calculated as shown.

It measures how quickly credit sales are converted to cash.

Norton Corporations accounts receivable turnover is 26.7. 16-*A related measure called the average collection period is computed as shown.

It measures how many days, on average, it takes to collect an accounts receivable.

It should be interpreted relative to the credit terms offered to customers.

Norton Corporations average collection period is 13.67 days. 16-*The inventory turnover is computed as shown.

It measures how many times a companys inventory has been sold and replaced during the year.

It should increase for companies that adopt just-in-time methods.

It should be interpreted relative to a companys industry. For example, grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn their inventory over slowly.

If a companys inventory turnover is less than its industry average, it either has excessive inventory or the wrong types of inventory. 16-**Norton Corporations inventory turnover is 12.73 times. 16-*A related measure called the average sale period is computed as shown.

It measures the number of days being taken, on average, to sell the entire inventory one time.

Norton Corporations average sale period is 28.67 days. 16-*Learning objective number 4 is to compute and interpret financial ratios that would be useful to a long-term creditor.

16-*Long-term creditors are concerned with a companys ability to repay its loans over the long-run. Creditors often seek protection by requiring that borrowers agree to various restrictive covenants, or rules. The information shown for Norton Corporation will be used to calculate ratios of interest to long-term creditors.

16-*The times interest earned ratio is calculated as shown.

It is the most common measure of a companys ability to protect its long-term creditors.

It is based on earnings before interest and income taxes because that is the amount of earnings that is available for making interest payments.

A ratio of less than one is inadequate.

Norton Corporations times interest earned ratio is 11.51 times. 16-*The debt-to-equity ratio is computed as shown.

It indicates the relative proportions of debt and equity on a companys balance sheet.

Creditors and stockholders have different views when defining the optimal debt-to-equity ratio.

Stockholders like a lot of debt if the company can take advantage of positive financial leverage.

Creditors prefer less debt and more equity because equity represents a buffer of protection.

In practice, debt-to-equity ratios from 0.0 to 3.0 are common. 16-*Norton Corporations debt-to-equity ratio is 0.48. 16-*Norton Corporations debt-to-equity ratio is 0.48. 16-*