Transfer Pricing

Definitions
A 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.

Purposes of transfer pricing

1. To provide information that motivates divisional managers to make good

economic decisions.
2. To provide information that is useful for evaluating the managerial and
economic performance of the divisions.
3. To intentionally move profits between divisions or locations.
4. To ensure that divisional autonomy is not undermined.

Purposes of transfer pricing

Information for making good decisions
Intermediate products = Goods transferred from the supplying to
receiving division.
Final products = Products sold by the receiving division to the outside
world
Example
Incremental cost of making intermediate product
Incremental further processing costs in receiving division
Market price of final product
No external market for the intermediate product and spare
capacity
Cost-plus 50% transfer price
Business will be rejected if TP set at 150

= 100
= 60
= 200
= 150

Purposes of transfer pricing

Evaluating managerial performance
TP of 60 incremental cost of supplying division would motivate correct
decision but it does not form a basis for measuring the performance of the
supplying division.
A conflict of objectives exists which can be difficult to resolve.

Transfer Pricing Methods

1. Market-based
2. Variable Cost
3. Full cost
4. Cost-plus a mark-up
5. Negotiated transfer prices

Transfers at Market
Price
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.
1. Where there is a perfectly competitive market for the
intermediate product, the current market price is the most
suitable basis for setting the transfer prices.
2. TP s will motivate sound decisions and form a suitable basis
for performance evaluation
3. 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.
4. A market price approach does not work well when the selling
division has idle capacity.

Transfers at the Cost to

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

Suboptimization Example
Oslo = Supplying division (No external market for the intermediate product)
Bergen = Receiving division (converts intermediate to final product)
Expected sales of the final product:
Net selling price
Quantity sold
()
Units
100
1 000
90
2 000
80
3 000
70
4 000
60
5 000
50
6 000
The costs of each division are:
Oslo
Bergen
Variable cost per unit
11
7
Fixed costs
60 000
90 000
The transfer price of the intermediate product has been set at 35 based on
a full cost plus mark-up.

Suboptimization Example

Suboptimization Example

Suboptimization Example

Suboptimization Example
35 TP does not motivate optimum output level for the
company as a whole.
To ensure overall company optimality the TP must be set at
VC of the intermediate product (i.e VC of 11 per unit or
11,000 per batch of 1,000 units).

Transfer Pricing Methods

Negotiated transfer prices
Most appropriate where there are market imperfections for the
intermediate product and managers have equal bargaining power.
To be effective managers must understand how to use cost and revenue
information.
Claimed behavioural advantages.

Limitations:
1. Can lead to sub-optimal decisions
2. Time - consuming
3. Divisional profitability may be strongly influenced by the bargaining
skills and powers of the divisional managers.
4. Inappropriate in certain circumstances (e.g. no market for the
intermediate product or an imperfect market exists).

Negotiated Transfer
Prices
A negotiated transfer price results from discussions
between the selling and buying divisions.
Advantages of negotiated transfer prices:
1.

They preserve the autonomy of the

divisions, which is consistent with
the spirit of decentralization.

2.

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.

Range of Acceptable Transfer

Prices

Upper limit is
determined by
the buying
division.

Lower limit is
determined by
the selling
division.

Harris and Louder An

Example
Assume the information as shown with respect
to Imperial Beverages and Pizza Maven (both
companies are owned by Harris and Louder).
Imperial Beverages:
Ginger beer production capactiy per month
Variable cost per barrel of ginger beer
Fixed costs per month
Selling price of Imperial Beverages ginger beer
on the outside market
Pizza Maven:
Purchase price of regular brand of ginger beer
Monthly comsumption of ginger beer

10,000 barrels
8 per barrel
70,000
20 per barrel
18 per barrel
2,000 barrels

Harris and Louder An

Example
The selling divisions (Imperial Beverages) lowest acceptable transfer
price is calculated as:
Transfer Price

Variable cost
Total contribution margin on lost sales
+
per unit
Number of units transferred

The buying divisions (Pizza Maven) highest acceptable transfer price is

calculated as:

Transfer Price Cost of buying from outside supplier

If an outside supplier does not exist, the highest acceptable transfer price
is calculated as:
Transfer Price Profit to be earned per unit sold (not including the transfer price)

Harris and Louder An

Example
If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy
Pizza Mavens demands (2,000 barrels) without sacrificing sales to other
customers, then the lowest and highest possible transfer prices are
computed as follows:
Selling divisions lowest possible transfer price:

Transfer Price 8 +

0
= 8
2,000

Buying divisions highest possible transfer price:

Transfer Price Cost of buying from outside supplier

Therefore, the range of acceptable

transfer price is 8 18.

= 18

Harris and Louder An

Example
If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice other
customer orders (2,000 barrels) to meet Pizza Mavens demands (2,000
barrels), then the lowest and highest possible transfer prices are computed
as follows:
Selling divisions lowest possible transfer price:

( 20 - 8) 2,000
Transfer Price 8 +
= 20
2,000
Buying divisions highest possible transfer price:

Transfer Price Cost of buying from outside supplier

Therefore, there is no range of

acceptable transfer prices.

= 18

Harris and Louder An

Example
If Imperial Beverages has some idle capacity (1,000 barrels) and must
sacrifice other customer orders (1,000 barrels) to meet Pizza Mavens
demands (2,000 barrels), then the lowest and highest possible transfer prices
are computed as follows:
Selling divisions lowest possible transfer price:

( 20 - 8) 1,000
Transfer Price 8 +
= 14
2,000
Buying divisions highest possible transfer price:

Transfer Price Cost of buying from outside supplier

Therefore, the range of acceptable

transfer price is 14 18.

= 18

Evaluation of
Negotiated TP
If a transfer within a company would result in higher overall profits
for the company, there is always a range of transfer prices within
which both the selling and buying divisions would have higher
profits if they agree to the transfer.
If managers are pitted against each other rather than against their
past performance or reasonable benchmarks, a noncooperative
atmosphere is almost guaranteed.

Given the disputes that often accompany the negotiation process,

most companies rely on some other means of setting transfer prices.

Resolving transfer
pricing conflicts
Dual rate TP system
Uses two transfer prices
1. Supplying division may receive full cost plus a mark-up so that it
makes a profit on inter-divisional transfers (e.g Oslo TP > 23).
2. Receiving division charged at VC of transfers thus motivating
managers to operate at the optimum output level for the company as
a whole.
3. Profit on inter-group trading removed by an accounting adjustment.

Not widely used because:

1.
2.
3.
4.

Use of two TP s causes confusion

Seen as artificial
Divisions protected from competition
Reported inter-divisional profits can be misleading

Resolving transfer
pricing conflicts
Variable cost plus a lump sum fee
Intended to motivate receiving division to equate VC of transfers with its
net marginal revenue to determine optimum company profit maximizing
output level.
Enables supplying division to cover its fixed costs and earn a profit on
inter-divisional transfers through the fixed fee charged for the period.
Motivates receiving division to consider full cost of providing
intermediate products/services (.TP = 11 MC plus 60,000 lump sum
plus a profit contribution in the example).

Domestic TP
conclusions
Competitive market for the intermediate product Use
market prices.
No market for the intermediate product or an imperfect
market Transfer at MC plus a lump sum or negotiation may
be appropriate in certain circumstances.
Use standard costs for cost-based TP s

International transfer
pricing

Where divisions are located in different countries

taxation implications become important and TP has
the potential to ensure that most of the profits on
inter-divisional transfers are allocated to the low
taxation country.

Practice Question
Division-B has asked Division-A of the same company to supply it with
6,000 units of a part this year to use in one of its products. Division-B has
received a bid from an outside supplier for the parts at a price of Rs.17 per
unit. Division-A has the capacity to produce 30,000 units of this part per
year. Division-A expects to sell 27,000 units of the part to outside
customers this year at a price of Rs.18 per unit. To fill the order from
Division-B, Division-A would have to cut back its sales to outside
customers.
Division-A produces part at a variable cost of Rs.9 per unit. The cost of
packing and shipping the parts for outside customers is Rs.1 per unit.
These packing and shipping costs would not be incurred on sales of the
parts to Division-B.
Required:
Calculate the range of transfer prices within which both the Divisions'
profits would increase as a result of agreeing to transfer 6,000 parts this
year from Division-A to Division-B.

Solution
From the perspective of Division B, profits would increase as a result of the
transfer if and only if: Transfer price Variable cost + Opportunity cost
The opportunity cost is the contribution margin on the lost sales, divided by the
number of units transferred:
Opportunity cost = [(Rs.18.00 - Rs.9.00 - Rs.1.00) 3,000*]/6,000 = Rs.4.00
* Demand from outside customers
27,000
Units required by Division B
6,000
Total requirements
33,000
Capacity
30,000
Required reduction in sales to outside customers
3,000
Therefore, Transfer price Rs.9.00 + Rs.4.00 = Rs.13.00. 1
From the viewpoint of Division A, the transfer price must be less than the cost
of buying the units from the outside supplier. Therefore, Transfer price
Rs.17.00.
Combining the two requirements, we get the following range of transfer prices:
Rs.13.00 Transfer price Rs.17.00.

Practice Question
An organization has two divisions, X-Division and Y-Division. X-Division produces
two products A and B. Product A is sold to external customers for Rs. 210 per unit.
The only outlet for product B is Y-Division. Y-Division supplies to an external market
and can obtain its semi-finished supplies (product B) from either X-Division or from
an external source. Division-Y currently has the opportunity to purchase product B
from an external supplier for Rs. 190 per unit. The capacity of X-Division is
measured in unit of output, irrespective of whether product A, B or combination of
both are being produced. The associated product costs are as follows:
Rupees
Product
A
B
Variable costs per unit
160
175
Fixed overheads per unit
25
25
Total costs per unit
185
200
Required:
Transfer price for the sale of Product B from X-Division under the following options:
(i) X-Division has spare capacity and limited external demand for product A
(ii) X-Division is operating at full capacity with unsatisfied external demands for
product A

Solution
X-Division is Operating at Full Capacity with unsatisfied demand
of A
If X-Div chooses to Supply to Y-Div then its Opportunity Cost is
Opportunity Cost = 210 -160 = 50
In this situation relevant cost of Supply = 175 +50 = 225