 Hello and welcome to the session in which we would look at the three common method for transfer prices. These three methods are usually taught in a cost accounting or a managerial accounting course. The reason I emphasize this point is because there are other methods that I cover in my international accounting or in my international tax lectures. But these lectures here are designed if you are taking a cost accounting or a managerial accounting course. If you are looking for tax, please see my international accounting course. And the three methods are intervention by top management. You establish a transfer price, either using a market-based or a cost-based and under cost-based. You could have cost-based purely cost-based or cost-based plus profit. And you are looking at a negotiated transfer price. Obviously, I'm gonna go over each method separately, explain it real quick, tell you what are advantages and disadvantages. One is it used, then we will work in example or two. But before I start, I would like to remind you that if you are an accounting student or a CPA candidate, I strongly suggest you check out my website, farhatlectures.com. Now, if you're taking a CPA course, like Becker, Roger, Wiley, Glyme or a CPA review course to be more specific. Look, keep your course, I don't replace your course. I can add to your course, I can add resources, I can add knowledge, I can teach you the material and as a result, you can add 10 to 15 points to your CPA exam. So my offer to you is this, are you willing to take your chances by trying my system, trying my website for one month and see if it's gonna help you, if it's not gonna help, you cancel. Your loss is $30 if you canceled, that's it. Your potential gain is adding points to passing the CPA exam. So your gain technically is unlimited. Are you willing to take that offer from me? Try it, see how it works. If it doesn't work, you cancel. Also, if not for anything, check out my website to find out how well is your university going on the CPA exam. This tells you how well your program, accounting program, how rigor or not rigor based on the pass rate. I do have the pass rate by university as well as the pass rate by section. I do also cover other courses like international accounting, as I said, will teach you a little bit more about transfer prices from a tax perspective. Please connect with me on LinkedIn if you haven't done so and check my LinkedIn recommendations. Those are the students that already used my system to pass the exam. Like this recording, share it, put it in playlist. If it benefits you, it means it might benefit other people. Connect with me on Instagram and Facebook. So we're gonna go ahead and look at each of these methods separately, starting with intervention by top management. So what is intervention by top management? It means top management at the headquarter or at the corporate office. When I say headquarter and corporate office, it means the same thing, tells you what to do. You don't make that division. You don't make that decision on the division level. So when is it usually used this method, intervention by top management? Remember, top management are busy at the headquarter. Usually it's done when the transfers are large, it means the dollar amount is high, and notice and, and the transfer are not frequent because top managers, they don't want to be running your division day, day in and day out. That's the reason for decentralization in the first place. Now, the disadvantage of this, some managers feel that they lost some autonomy because you are taking away the decision-making from them and you could have dispute between the managers and the corporation, the headquarter, or the corporate office. That could happen because they're not happy with the decision. And again, it defeat the purpose of decentralization because managers, they lose their autonomy. They lose their decision-making process. That process is outsourced back in quote, outsourced back to the headquarter, to the corporate division. The managers feel that they lost control. There's a loss of control, which is not good for motivation. So that's intervention by top management. And usually when they intervene, they tell you what the price is and you have to usually accept. The second method is establish a transfer price policy. Basically you set up the policy and say, this is our policy, we're gonna follow this policy. Now under establishing a policy, you could establish a market-based transfer policy or a cost base. And under cost base, we have cost plus transfer. Now on the prior session, I talked a little bit more about a perfect intermediate market and there's no intermediate market. It means if there is a market price, we could use the market-based transfer price. What does it mean? Market base, it means whatever the market price for our product that we are selling, if there's a market price, we're gonna use that market price. So it's often used when we have a perfect intermediate market. And in my session and the prior session, when I spoke about market price, we're selling milk. You remember we're selling milk to the cheese factory. So if the barrel of the milk in the market is for $35, then what we do is we charge the buyer $35 because that's the market price. What happened if we charged them more than $35? They don't buy it from us. They can go somewhere else and buy $435. Then we cannot sell it less than $35 because if we sell it less than $35, we'll be losing a dollar on each sale while we can sell this milk in the open market. So this is when the market-based is used and there's a perfect market. So we can sell our product to an insider or to an outsider and the buying division, they can buy it from us or they can buy it from somewhere else. Now we could always give a small discount to the buying division, especially if we can save on logistics. For example, if the raw material and the production facilities are close to each other, then we can deliver the product at a cheaper cost than if they buy it from a third party that's far away physically from their production capacity. So we might have the ability to give a small discount on certain circumstances. Here under the market price, the headquarter or the corporate office does not care whether we purchase it from our division or somewhere else, whether we sell it to an internal division or somewhere else. So basically it's market-based. You determine the buyer and the seller determine what's in their best interest and they will do so. Cost-based transfer price just like as it sounds, it's based on cost. So we determine our cost. Now what cost do we use? Well, we could use variable cost or we could use variable and fixed cost, which is basically full costing. Well, in certain circumstances, we can use variable and others we could use variable. And fixed, we would look at some examples later on. So what is the advantages of using cost-based? Cost-based is basically easy to compute because you have all the data, especially when no market exists. What are you gonna do? Well, I'm gonna use my cost. Now you could use cost eventually plus some profit, cost plus, but it's easy to come up to the cost and it's easy to understand whether you are the manager buying or the manager selling. Look, I'm charging you my cost and here's my cost. Now, there's some, here we're gonna talk about capacity a little bit and we're gonna talk about capacity more when we actually work examples. If the seller is below capacity, it means we have access capacity. What does it mean access capacity? Going to the barrels of milk, let's assume we can produce 100,000 barrels a month and we can only sell 80,000 to an outsider. Well, we have access capacity. We have 20,000 barrels of milk that we're not selling. That means we can sell it to somewhere else. We have access capacity. Usually if we have access capacity, we have no opportunity cost lost. Simply put, if we cannot sell it to someone else, we should sell it to the, our sister company or to the insider division. Therefore, usually we can charge them only variable cost. Why? Because as long as we cover our variable cost, fixed cost exists. Now we can charge them more, but if we charge them variable cost, the cheese division that bought the milk can make and show more profit. But usually variable cost will be good enough for us. If we sell at variable cost, really the seller becomes a cost center. In other words, I'm not making a profit. Therefore, I am no longer a profit center. I am a cost center. And here under those circumstances, there's no incentive to control cost. If you are a cost center, okay. Well, there is incentive to keep your costs low, but from a profitability perspective, you're not making any profit. Therefore, you don't care really to control cost. You can increase your budget. If the seller at capacity or have no access capacity, let's assume you can produce 100,000 barrels of milk per month and you can sell them all. Then you have no access capacity. Usually under those circumstances, you will charge the buying division full absorption cost, which is fixed cost and variable cost. But again, there might be a room for some reduction in the price. When we look at examples, we'll talk about this. Also, there's another subtype of cost basis, cost plus transfer price. So you'll take your cost and tack to it 10%, 15%, 20%. And basically, it's the cost plus transfer price. This is usually done when if you work with the government, the government wants to, yeah, they want you to make a profit, but a reasonable profit. Therefore, they'll have a policy. I'm gonna pay you your cost plus five or to 15%. But that's not the same concept that it has nothing to do with transfer pricing. So we're gonna take the cost, plus we're gonna share the profit between the seller and the buyer division. So I'm gonna take some profit, you're gonna make some profit. So this is when we have an established transfer price policy, whether it's cost or market-based, that's it. We said, you take care of this and we're done with this. Negotiated prices, well, as the term suggests, it's you're negotiating. What does that mean? It means you are acting independently from anyone. You negotiate, you determine the price, whether that other party wants to take it or not, that's up to you. You are the CEO of your own division. And here you have the flexibility and you have full control of your division. So your autonomy is truly respected by the corporate office. So allow the headquarter, the corporate office to focus on other issues. And that's the purpose of decentralization. You worry about data, the operation, we worry about the big picture. Here, usually you are gonna sell it more than the variable cost. The negotiated transfer price, it's usually more than the variable cost, but below the market price. Because if you sell it above the market price, it can go somewhere else, but you also want to make some profit. So more than the variable cost below the market price, both parties are happy. The disadvantages of this is negotiation takes time and effort. So that means money, effort, waste of time because maybe we have to negotiate, we negotiate every deal. And party with a stronger negotiation skills is better off because they can negotiate better. They might be able to get a lower cost as a result. They can show more profit as a result. They can get more incentive as a result. They, their negotiating position is even getting stronger. So, and it will snowball against the weak party. At the end of this recording, I'm gonna ask you to like it, share it, put it in playlist. And once again, if you're studying for the CPA exam, I strongly suggest you check out my website, farhatlectures.com. Again, I am not replacing your CPA review course. I can be a useful addition and a very good useful addition. Or if you are taking accounting courses. Anyhow, study hard, stay safe and good luck.