Describe salient features of cost based & market price based transfer pricing methods.

Cost-based Transfer Prices:

The transfer price is based on the production cost of the upstream division. A costbased transfer price requires that the following criteria be specified: Actual cost or budgeted (standard) cost. Full cost or variable cost. The amount of markup, if any, to allow the upstream division to earn a profit on the transferred product.

Cost-based transfer prices can also align managerial incentives with corporate goals, if various factors are properly considered, including the outside market opportunities for both divisions, and possible capacity constraints of the upstream division. First consider the case in which the upstream division sells the intermediate product to external customers as well as to the downstream division. In this situation, capacity constraints are crucial. If the upstream division has excess capacity, a cost-based transfer price using the variable cost of production will align incentives, because the upstream division is indifferent about the transfer, and the downstream division will fully incorporate the companys incremental cost of making the intermediate product in its production and marketing decisions. However, senior management might want to allow the upstream division to mark up the transfer price a little above variable cost, to provide that division positive incentives to engage in the transfer. If the upstream division has a capacity constraint, transfers to the downstream division displace external sales. In this case, in order to align incentives, the opportunity cost of these lost sales must be passed on to the downstream division, which is accomplished by setting the transfer price equal to the upstr eam divisions external market sales price. Next consider the case in which there is no external market for the upstream division. If the upstream division is to be treated as a profit center, it must be allowed the opportunity to recover its full cost of production plus a reasonable profit. If the downstream division is charged the full cost of production, incentives are aligned because the downstream division will refuse the transfer under only two circumstances: - First, if the downstream division can source the intermediate product for a lower cost elsewhere;

- Second, if the downstream division cannot generate a reasonable profit on the sale of the final product when it pays the upstream divisions full cost of production for the intermediate product. If the downstream division can source the intermediate product for a lower cost elsewhere, to the extent the upstream divisions full cost of production reflects its future long-run average cost, the company should consider eliminating the upstream division. If the downstream division cannot generate a reasonable profit on the sale of the final product when it pays the upstream divisions full cost of production for the intermediate product, the optimal corporate decision might be to close the upstream division and stop production and sale of the final product. However, if either the upstream division or the downstream division manufactures and markets multiple products, the analysis becomes more complex. Also, if the downstream division can source the intermediate product from an external supplier for a price greater than the upstream divisions full cost, but less than full cost plus a reasonable profit margin for the upstream division, suboptimal decisions could result.

Market-based Transfer Prices: In the presence of competitive and stable external markets for the transferred product, many firms use the external market price as the transfer price.
Microeconomic theory shows that when divisional managers strive to maximize divisional profits, a market-based transfer price aligns their incentives with owners incentives of maximizing overall corporate profits. The transfer will occur when it is in the best interests of shareholders, and the transfer will be refused by at least one divisional manager when shareholders would prefer for the transfer not to occur. The upstream division is generally indifferent between receiving the market price from an external customer and receiving the same price from an internal customer. Consequently, the determining factor is whether the downstream division is willing to pay the market price. If the downstream division is willing to do so, the implication is that the downstream division can generate incremental profits for the company by purchasing the product from the upstream division and either reselling it or using the product in its own production process. On the other hand, if the downstream division is unwilling to pay the market price, the implication is that corporate profits are maximized when the upstream division sells the product on the external market, even if this leaves the downstream division idle. Sometimes, there are cost savings on internal transfers compared with external sales. These savings might arise, for example, because the upstream division can avoid a customer credit check and collection efforts, and the

downstream division might avoid inspection procedures in the receiving department. Market-based transfer pricing continues to align managerial incentives with corporate goals, even in the presence of these cost savings, if appropriate adjustments are made to the transfer price (i.e., the market-based transfer price should be reduced by these cost savings).

However, many intermediate products do not have readily-available market prices. Examples are shown in the table above: a pharmaceutical company with a drug under patent protection (an effective monopoly); and an appliance company that makes component parts in the Parts Division and transfers those parts to its assembly divisions. Obviously, if there is no market price, a market-based transfer price cannot be used. A disadvantage of a market-based transfer price is that the prices for some commodities can fluctuate widely and quickly. Companies sometimes attempt to protect divisional managers from these large unpredictable price changes.

Explain the problem faced in pricing corporate services staff to biz. Unitassume profit centers decentralization? Services are intangible in nature. This characteristic of services makes it difficult for pricing. Charging business units for services furnished by corporate staff units becomes challenging work due to intangibility of services. While pricing corporate services, we exclude the cost of central service staff units over which business units have no control (e.g., central accounting, public relations, and administration). If these costs are charged at all, they are allocated, and the allocations do not include a profit component. The allocations are not transfer prices. We need to consider two types of transfers: For central services that the receiving unit must accept but can at least partially control the amount used. For central services that the business unit can decide whether or not to use. Business units may be required to use company staffs for services such as information technology and research and development. In these situations, the business unit manager cannot control the efficiency with which these activities are performed but can control the amount of the service received. There are three schools of thought about such services. One school holds that a business unit should pay the standard variable cost of the discretionary services. If it pays less

than this, it will be motivated to use more of the service than is economically justified. On the other hand, if business unit managers are required to pay more than the variable cost,they might not elect to use certain services that senior management believes worthwhile from the company's viewpoint. This possibility is most likely when senior management introduces a new service, such as a new project analysis program. The low price is analogous to the introductory price that companies sometimes use for new products.A second school of thought advocates a price equal to the standard variable cost plus a fair share of the standard fixed costs-that is, the full cost. Proponents argue that if the business units do not believe the services are worth at least this amount, something is wrong with either the quality or the efficiency of the service unit. Full cost represents the company's long run costs, and this is the amount that should be paid. A third school advocates a price that is equivalent to the market price, or to standard full cost plus a profit margin. The market price would be used if available (e.g., costs charged by a computer service bureau); if not, the price would be full cost plus a return on investment. The rationale for this position is that the capital employed by service units should earn a return just as the capital employed by manufacturing units does. Also, the business units would incur the investment if they provided their own service. Optional Use of Services In some cases, management may decide that business units can choose whether to use central service units. Business units may procure the service from outside, develop their own capability, or choose not to use the service at all. This type of arrangement is most often found for such activities as information technology, internal consulting groups, and maintenance work. These service centers are independent; they must stand on their own feet. If the internal services are not competitive with outside providers, the scope of their activity will be contracted or their services may be outsourced completely .For example, Commodore Business Machines outsourced one of its central service activities-customer service-to Federal Express. James Reeder, Commodore's vice president of customer satisfaction, said," At that time we didn't have the greatest reputation for customer service and satisfaction. But this was FedEx's specialty, handling more than 300,000 calls for service each day. Commodore arranged for FedEx to handle the entire telephone customer service operation from FedEx's hub in Memphis. After losing $29 million online the previous year, Borders Group turned to rival Amazon.com to manage its online sales. Borders get to maintain an Internet sales channel and gains the operational effectiveness provided by Amazon.com while being able to focus on the growth of its bricks and mortar business. In this situation, business unit managers control both the amount and the efficiency of the central services. Under these conditions, these central groups are profit centers. Their transfer prices should be based on the same considerations as those governing other transfer prices.