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Pricing of Joint Products and Transfer Pricing

Pricing of Joint Products and Transfer Pricing. Web Appendix 9B. Slides developed by: William Rentz & Al Kahl University of Ottawa. Joint Products. Interdependencies in costs occur in products that are produced simultaneously or jointly.

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Pricing of Joint Products and Transfer Pricing

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  1. Pricing of Joint Products and Transfer Pricing Web Appendix 9B Slides developed by: William Rentz & Al Kahl University of Ottawa © 2006 by Nelson, a division of Thomson Canada Limited

  2. Joint Products • Interdependencies in costs occur in products that are produced simultaneously or jointly. • E.g., Beef & Hides in steers and Natural Gas & Crude Oil in oil well drilling are ‘jointly produced’. • Suppose beef & hides are produced in FIXED PROPORTIONS : 250 kilos of Beef + 7.5 square metres of hides for 1 steer. • Two cases: (1) No excess of either product and (2) one product has an excess. © 2006 by Nelson, a division of Thomson Canada Limited

  3. Steers:The Case with No Excess of Either Hides or Beef Two Demand Curves: Hides (H) & Beef (B) Two MR Curves: Hides & Beef MRB DH DB © 2006 by Nelson, a division of Thomson Canada Limited steers (T) MRH

  4. 2 MCT MRT Find where MRT = MCT to find the optimal of steers. DH DB © 2006 by Nelson, a division of Thomson Canada Limited steers (T) MRH

  5. 3 MRT MCT At the optimal number of steers, find the prices of beef & hides on their respective demand curves PB PH DH DB © 2006 by Nelson, a division of Thomson Canada Limited steers (T) MRH T

  6. Suppose the Atkins’ Diet encourages more demand for beef • Demand for beef shifts up and out • MR for steers shifts up and out • The optimal number of steers rises • The price of beef rises, but… the price of hides declines. © 2006 by Nelson, a division of Thomson Canada Limited

  7. Excess of One of the Joint Products • Excess means the price would be ZERO • The solution is to hold back some of the excess to reach the Unit Elastic Point on the Demand Curve. • This Maximizes Total Revenue. © 2006 by Nelson, a division of Thomson Canada Limited

  8. Transfer Pricing • Vertically integrated firms “sell” intermediate goods from one division to the other. The internal price used is called the transfer price. Car Frames Fisher Body GM Chevy Division Transfer prices paid Fisher Body Car Frames (a division of GM) sells to Chevrolet (another division of GM) GM Chevrolet Division Buys Fisher Body Car Frames © 2006 by Nelson, a division of Thomson Canada Limited

  9. Transfer Pricing serves two functions: • 1. It measures the marginal value of the resource • It provides a performance measure of resources used, including the totalvalue of resources • Each division can be a profit centre. For International Firms, transfer pricing may assist in reducing worldwide taxation, although ability to reduce taxes is limited since the CRA requires arm’s length prices. © 2006 by Nelson, a division of Thomson Canada Limited

  10. Create Transfer Prices Similar to Competitive Market Prices • Disagreementsacross divisions are common • “Selling” Division wants a HIGH transfer price! • “Buying” Division wants a LOW transfer price! • When External Markets exist, use those prices for transfer (a market-based competitive price) sell to others @ “P” final car assembly motor assembly purchase motors from others @ “P” © 2006 by Nelson, a division of Thomson Canada Limited

  11. Optimal Transfer Pricing © 2006 by Nelson, a division of Thomson Canada Limited

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