 Hello and welcome to this session in which we would look at transfer prices. I'm gonna be explaining transfer prices from the concept of performance measurement rather than tax perspective. I do have the tax perspective in my international accounting course. So if you are looking for transfer prices as it affect the tax, please Google or YouTube far hat transfer tax and you will find my lecture. The reason we're doing transfer taxes is because in the prior session we looked at decentralization in a company and when a company is decentralized what's gonna happen is each division will be judged based on return on investments, economic value added and residual income. So transfer prices is important because when one division sells to another division the selling price of division A will be the cost of division B. So that's why it's gonna affect their performance measurement and this is how I'm gonna be explaining transfer prices. Now before I start I would like to remind you that if you are an accounting student or a CPA candidate please check out my website farhatlectures.com for additional resources especially if you're studying for your CPA exam. This topic is covered on the CPA exam. I don't replace your CPA prep course. I don't replace your CPA review course whether you're taken back or Roger Guileague-Lime or any other course. I can be a useful addition. I can be that vitamin, that supplement that's gonna add 10 to 15 points to your exam because I do explain the materials in details. I don't assume any prior knowledge. And basically my offer to you is this, are you willing to try my system for $30 a month for just to try it to see if you could improve your grade on the CPA exam. Simply put your risk is $30. Your potential gain is passing the exam. Simply put your potential gain is unlimited if you want to quantify it. And you don't have to invest thousands of dollars with my course, you try it, $30. You like it, you keep it for the next month. You don't, you cancel, life goes on. And if not for anything check out my website to determine how well your university is doing on the CPA exam. This is a list of all the courses that I cover. Please link with me on LinkedIn if you haven't done so check out my LinkedIn recommendation to see how students use my system to pass the CPA exam. Please like this recording and share it with others on YouTube, connect with me on Instagram and Facebook. So let's go back to transfer prices and what's the issue with transfer prices? Again, as we said, we might have various divisions that they sell to each other. And as a result, we might have what we called agency problem where internal prices between divisions are set to benefit the managers of the division rather than the company as a whole. What does that mean? It means the manager is making decision based on prices to benefit themselves, not the firm. This is what basically agency problem is. So part of transfer, transfer prices, it could amount to an agency problem. So simply put, we're gonna be working with the selling division. And when the selling division sells, they record the transaction as if they sold it to an external customer, let's assume they're selling milk, we have farmers and they're selling to another division in the company where they produce the cheese. So they need the milk to produce the cheese. So those are the two divisions that we are dealing with in this example. And when they purchase from the milk division, they record the transaction as if they purchase the items from an external supplier. Although both of these companies are under the umbrella of one parent company. So this is where transfer prices occur. They are in the same under the same umbrella. Now transfer, so what is a transfer price? Simply put, the transfer price is the price that the milk division charges to the cheese division. They have to assign a value to the goods and services. Simply put, if they don't assign a value, let's assume they give it to them at cost, then the milk division would no longer be considered a profit center, it will be considered a cost center. Then it will be evaluated differently. We are assuming that the milk division is a profit center. This means they produce revenues and they incur expenses. Therefore, when they sell to the cheese division, that is an expense for them. That's a cost of goods sold. So it's the amount used by each division to record the event. Now why is this important? Why? Because if we are saying the milk and the cheese division, they belong to the same company. So why do we care about transfer prices? Because at the end of the day, what we care about is the whole company overall. Well, if we are a profit division, we have to make decisions about revenues and expenses. We have to cost the product. How much should we charge for the product? Because our division's performance in the eyes of the corporate, the corporate means the main company, will matters. Whether we are making profit, a lot of profit, a little bit or none. It's because they're gonna evaluate our performance based on residual income, return on investments and economic value added. If you don't know what these terms are, look in the prior session because those we already covered, those when we covered decentralization. Basically, we are being evaluated based on our performance. And of course, transfer prices is extremely important for tax purposes. Think about when one company has many divisions in different countries. And that matters substantially now because now it's affecting the bottom line of the company. But again, as I told you at the beginning of this recording, I do not discuss tax consequences. Please go to my international accounting course and you will see what are the tax consequences when it comes to transfer prices. Now the best way to illustrate the idea of transfer prices is to walk you through an example and I'm gonna be using the farm, which is the milk as the selling division and the cheese producers is the buying division. And those two companies, they're under the same corporate umbrella. So let's start with the first example. As we said, as we have a buying division and a selling division. And we are selling barrels of milk to the buying division, which is the cheese manufacturing company. So what is the profit for the selling division? Well, the profit for the selling division when they sell to the cheese division, it's whatever they charge them, which is gonna be calling the transfer price wherever they charge the buying division minus cost of goods sold. Remember cost of goods sold could be variable cost, fixed cost, a combination, but for the sake of simplicity, we're gonna say the transfer price minus cost of goods sold. So let's assume our cost to produce the sparrow of milk is $20. We're gonna sell it for $35. Therefore, the profit for the selling division is $15. Simply put, the transfer price minus cost of goods sold will give us $15 for the selling division. Now, what is the buying division profit? Well, we're gonna assume that the buying division can sell the cheese, the final product that they're producing at $100. Well, it's gonna cost them $35 from the selling division for the milk. Then they're gonna have to incur an additional $40 in cost. As a result, they're gonna make a profit of $25, which is $100 minus $35, minus $40, minus $35, minus $40. Remember, the $35 is coming from the selling division. Therefore, they're gonna make a profit of $25. So let's take a look at the company overall, what happened. For the company overall, for this company overall, sales revenue is the sales only to the external party, which is the $100 minus the cost of goods sold in the selling division, minus the additional cost, which is 100 minus 20 minus 40 equal to $40. So notice, the profit for the whole firm is the profit of the seller's profit, the $15, plus the buyer's profit, which is $25. So it doesn't matter, $40 for the whole company, $15 was for the selling division, $25 was for the buying division. Let's change the scenario a little bit, just to start to have a feeling the effect of the transfer pricing. Let's assume cost of goods sold for the selling division is still 20, but they happen to charge $60. So what's the profit for the selling division? Well, the profit for the selling division now is $40. They sold it for 60, their cost is 20. Let's take a look at the buying division. It's the manufacturing facilities where they produce the cheese. They're gonna sell it to the external customer for $100. They're gonna have to account for $60 for the milk. They're gonna have to incur an additional $40. Therefore their profit is zero because 100 minus 60 minus 40 will give you a profit of zero. They will break even. Let's take a look at the company overall. The company overall, it does not really matter. We count the sale for the external party, which is $100, minus cost of goods sold in the selling division in the farm, on the farm to produce the milk, minus $40 additional cost. Therefore the total profit is $40. Still it's the seller's profit 40 and the buyer's profit is zero. So notice what happened. The company overall was not affected. However, under this scenario, the milk producing division would look very profitable. They will get all the resources. Their managers get all the bonuses. While the cheese producing division, they would look they are barely making any money. Actually they're not making any profit. Let's switch the scenario a little bit. Cost of goods sold is 20 for the milk division. They sold it for $20. What will be their profit? Their profit will be zero. Here's what's gonna happen. In the cheese division, they're gonna sell it for $100. They're gonna have to, they account for $20 from the milk division. They incur $40 an additional cost. Therefore the profit is 100 minus 20 minus 40. Their profit is $40. Now it's the opposite. The milk division would look like they are not making any profit. Therefore they will not get any additional resources or bonuses. The cheese division here will get the bonus because they are making all the profit for the company. But notice what's happening here. Hopefully you're catching on. That it's $40, but how we split that $40 matters. I'll split this $40 matter. So the question is what should be the optimal transfer price? And what's the optimal transfer price? It's what's the best price that they should charge each other, the milk and the cheese division. So the transfer price that leads both division to make decisions that are in the best interest of the firm. Now we kind of, kind of we know as long as we can keep it between certain amount, we're gonna find out what certain amount is, both party will be happy. So the transfer price between the both division, what should be that optimal price? It seems to be between 20 and 60, okay? As an optimal price. Why? Because anything above 20, anything above 20, the milk division will make profit, okay? Up to 60. If they charge more than $60, if they think about it, if they charge more than $60, if they charge $62, let's assume they charge $62, they will make more profit. But what's gonna happen, the cheese division, they will be at a loss of $2. So it seems 20 to $60 seems to be an optimal price. That seems to be. However, in the real world, we have to take into account other consideration. Here we're gonna be introducing the idea of external market. So in the real world, we're gonna also make an assumption that you could have a perfect intermediate market or no intermediate market. What does intermediate market and no intermediate market means? Intermediate market means there is a market price for this product that we are selling and we can sell it on outsider. No intermediate market means there is no market price. Simply put, if you remember, we can sell the selling division, they can sell the milk to the cheese manufacturing company or they can sell the milk to a third party. Also, the cheese division, they can get their supply from somewhere else. So here what's happening, we have a perfect intermediate market, where if I don't like your prices, I can go somewhere else. If I don't like your prices, I can sell it somewhere else. If I don't like your prices, I can supply myself from somewhere else. So let's talk about what would happen under intermediate market and no intermediate market. So what are the features for intermediate market? So simply put, buyers can buy any quantity without affecting the price. It means there's plenty of supply. The seller can sell any quantity without affecting the price. So simply put, there's plenty of supply and demand. It's not an issue. It's not gonna affect the price. Both buyers and sellers are price setters. Simply put, price setters means the market sets the price. So there's a market price and both of them, they want this market price. They don't want to pay more or less. So what will be the optimal price if we have an intermediate market? Well, the answer is it's the market price. If we have an intermediate market for the product, the best price for both parties is the intermediate price. Now, why would that be the case? Let's think about it and let's think about it. Well, if we charge them, let's assume the selling company, the milk division, sells low, if the price is lower, okay, let's assume, let's assume the price, let's work an example on the next page. Let's assume the market price is $35. It's better to explain it with numbers. Assuming the market price is $35, here's what's gonna happen. The profit for the selling division will be, if the cost of goods sold is 20, the transfer price is 35, then their profit is 15. So guess what? The selling division, any price 35 or above, which is the market price, they will accept it. Why? Because let's assume the cheese division, they're willing to pay 38. Well, the milk division will be very happy. They will supply as much as they can. Let's assume the cheese division wants to buy it for 33. Well, the milk division, they would say, no, I'm sorry, we're not gonna sell it to you at 33 because we can sell it for 35. So notice, if they sell it more than the market price, they're gonna be very happy. If they sell it less than the market price, they won't sell it less than the market price to the cheese company to supply them because they can sell it somewhere else at 35. There's plenty of supply, plenty of demand for that price. And this is what we meant by any lower supplier will go outside. The suppliers will not supply less than 35, any higher. And let's think about it from the cheese manufacturing facility. If the milk division wants to charge them $38, they will not accept. Why not? Because they can go somewhere else and buy it for 35. If the cheese division charged them 34, they'll be bringing it on because they'd save in a dollar from going to the outside. So simply put in an intermediate market, the best price. That's what you need to know about intermediate market. This is the answer. What's the optimal price? The optimal price is the intermediate market price if we have an intermediate market because everyone is happy and there's no need for negotiation. There is no need for complication. Now we're gonna look as if there is no intermediate market. So what does it mean no intermediate market? It means the product is so specialized that there is no market for it. If we want to look up the price, there is no price. Think about if we are producing screws for a machine and those screws are only for that specific machine. So there's no market price for them or the corporate division, the corporate headquarter, they don't want us to buy and sell to an outsider. So any external buying and selling is banned. We have to purchase from our sister companies. Why? Because that's what the headquarter want us to do. So we're gonna assume that the fixed cost is irrelevant in our decision and there are plenty of capacity. So we're not taking capacity into consideration. Look, if you are the seller, if you are the milk company, your transfer price should not be less than the variable cost. Think about it. What happened if, let's assume for that $20 for the milk company, let's assume for the sake of simplicity, this is their variable cost per barrel of milk. Well, guess what? They cannot sell it for less than 20. Because if they sell it for less than 20, the more they produce, the more they lose. Why would you keep on losing money? So they will not transfer if the transfer price for the seller for the milk division is less than $20. They have this incentive to sell and they will not transfer. Simply put, they will not do it because it will not make any sense unless the corporation wants to subsidize that may no longer become a profit center. We're assuming here you are a profit center. Now, what happened if the transfer price, if the transfer price, they're charging them some price greater than the final price minus the buyer variable cost. So we're gonna assume the buyer variable cost is $40. So if they charge them any price above 60, which is the difference between the final market price, we're assuming the final market price is $100. We're still working with the same example, minus $40 that the cheese division will have to incur. If they sell it to them at 61, then guess what? Then the buyer would lose money. Why? Because if they sell it, they're gonna sell it at 100, their cost is 101, they're gonna be losing $1. So anything above 60, they will not do it. So no transfer will take place, any price greater than the final market price minus the buyer variable cost. So what is the best transfer price? The best transfer price is the seller's variable cost. Again, assuming we have enough capacity. And assume it's $20, it means we should only charge, the milk division should only charge $20. You might be saying, why not? Why shouldn't they charge up to $60? What's gonna happen is this, the lower the price from the milk and division. Remember, we're assuming the final selling price is 100, okay? True, today the final market price is 100, but that's a market price. What happened if this price goes down to 60 or go down to 80? Okay, if we sell it to them at 60, they have to incur an additional $40, then they are losing, okay? Because now the market price is 80. So this way, if we provide it to them at $20, they have the widest range of pricing power. So if the price went down, the cheese division would still make money. Because remember, now we cannot sell it on outsider. Therefore, if we cannot sell it, they really will not make any profit here. Just basically we are kind of supplying only our company. So simply put, it would look something like this. Cost of goods sold is $20. Actually we would love any price above $20, but we will not do that. We charge, the best is to charge them only $20. And the buying division would absorb any price up to $60, but you don't want to do that. You want to give the company, you want to transfer the milk at a price of $20, okay? And remember, they're gonna add $40 to it. Therefore, the cost will be 60, okay? Now for the company, as long as the final price for the whole company is above 60, the company is happy. The firm is profitable overall, okay? Well, if the selling price is exactly 60, we are breaking even. Any selling price less than 60, I'm sorry, it should be greater than 60. Oh, this is selling price. Selling price less than 60. Well, if the selling price is less than 60, it doesn't matter. The company will not make any profit. Therefore, we assume there are no transfer. So that's why the best transfer price is the variable cost of the selling division. So give it to them at 20. This gives the company overall the why the strange of selling prices because this price of 100 might drop. And if it drops, you want to give the cheese division enough pricing power, enough pricing power so they can still make a profit. And the company overall will be making a profit because the final product that we're selling is cheese, not milk. That's the assumption, not the assumption, that's the implied assumption here, that we want to make profit on the cheese, not the milk. At the end of this recording, I'm gonna ask you to like this recording, share it, and once again, if you are a CPA candidate, please check out my website forhatlectures.com. Also, if you are an ACC candidate or a CMA candidate, or obviously an accounting student, I have plenty of resources that's gonna help you with your courses. Study hard, good luck, and of course, most importantly, stay safe.