TRANSFER PRICING
TRANSFER PRICING
Price at which goods or services are transferred from one
department to another , or from one member of group to
another
This a way of promoting divisional autonomy without
prejudicing measurement of divisional performance or
discouraging overall corporate profit maximization
They should be set at level which ensures that profits for
FIRM as a whole are maximized
Is used when divisions of a firm need to charge other divisions
of same firm for goods and services they provide for them
When is it that transfer pricing
needed:
Needed when an organisation has been
decentralized into divisions
Needed when inter-divisional trading of goods
or services occurs
Objectives of Transfer Pricing
Goal Congruence: Transfer prices should encourage
divisional managers to make decisions in the best interests of
the organisation as a whole
Divisional Autonomy : Divisional managers should be free to
make their own decisions. A transfer pricing system should
help eliminate the head office telling divisions what to do
Divisional Performance Evaluation :-Transfer prices should
be "fair" and allow an objective assessment of divisional
performance
NB:Goal congruence must take priority.
Problems with transfer pricing
Maintaining the right level of divisional autonomy: There
is a possibility of emergence of divisions into number of self-
interested segments, each acting at times against wishes and
interests of other segments
Ensuring divisional performance is measured fairly: since
profit centre performance is measured according to profit they
make, no profit centre will want to do work for another and
incur costs without being paid for it
Ensuring corporate profits are maximized: due to
disagreements about how work should be transferred
between divisions and how many sales divisions should make
to external markets
Solutions to abovesaid problems:
Transfer price must provide an artificial selling price that
enables transferring division to earn a return for its efforts and
receiving division to incur a cost for a benefits received
Transfer prices be set at level enabling profit centre
performance to be measured commercially
Transfer price should encourage profit centre managers to
agree on amount of goods and services to be transferred,
which will also be at level that is consistent with aims of
organisation as a whole
Potential benefits of transfer pricing
Prevent dysfunctional decision making
Ensure that divisional autonomy is not undermined
Lead to goal congruence
Used as a reasonable measure of managerial
performance
Opportunity Cost Approach
Supplying Division Perspective
•The selling division will accept a minimum transfer price equal
to:
Marginal (variable cost) + opportunity cost
The opportunity cost is usually the lost contribution from
external sales, either of:
-the same product subject to the transfer price; or
-other products which the supplying division makes
Scenario 1—Opportunity Cost Is Zero
When to use:
No external market
Or
External market but spare capacity and No
production constraints
RULE: In this situation, opportunity cost is zero
because internal transfers do not reduce
contribution from external sales
Example 1
Division Buy requires some components for its electronic games
console. Division Sell has some spare capacity and could make
the components for a variable cost of $60 each.
Required:
(a)Calculate the minimum transfer price acceptable to Division
Sell.
(b)State what will happen if Division Buy can buy externally for
$55.
(c) Conclude whether the actions of Division Buy and Division
Sell in part (b) lead to goal congruence
Scenario 2—Opportunity Cost Arises
An opportunity cost arises when an internal sale sacrifices an
external sale.
When used:
External market exists
And
Supplying division at full capacity
Example 2
Division Red makes Product Y and Product Z. The maximum
capacity of the factory is 5,000 units per month in total. This
capacity can be used to make either 5,000 units of Product Y or
5,000 units of Product Z, or any combination of the two.
Y Z
Selling price $12 $16
Variable cost $9 $11
Extra cost if sold externally $1 $1
Contribution $2 $4
Required
(a)Determine which product Division Red would make, and what
would be the monthly contribution of the division.
(b)Division Blue has asked Division Red to supply 1,000 units of
Product Y per month. Determine the minimum transfer price
which would be acceptable to Division Red.
(c) Division Blue now informs Division Red that it can buy
product Y from an external supplier for $11 per unit and is not
prepared to accept a price above this from Division Red. Explain
what would happen if both divisions were given autonomy to
make their own decisions. Comment on whether this benefits the
company as a whole
Buying Division Perspective
The maximum transfer price acceptable to the buying division
will be the lower of:
-the external market price (if an external market exists); or
-the net revenue of the buying division.
The net revenue of the buying division means the ultimate
selling price of the goods/ services sold by the buying division,
less the cost of those goods incurred by the buying division.
Example 3
Division I is an intermediate division. It supplies a special
chemical to division F, the final division. Division I has spare
capacity. Output of the chemical is limited. Variable cost per kg
is $500. No external market for the chemical exists. Division F
processes the chemical into the final product. Each unit of the
final product requires 1 kg of the chemical. Demand for the final
product exceeds production. Selling price per unit of the final
product is $1,000. The further processing cost per unit in
Division F is $200
Required
a)Calculate the maximum price Division F will be prepared to
pay for one kg of the chemical.
(b) Calculate the minimum price Division I will accept for 1 kilo of
the chemical.
(c) Comment on the performance evaluation issues if:
(i)a transfer price of $500 is used
(ii) a transfer price of $800 is used.
(d) Suggest an alternative transfer price which would lead to a
fairer evaluation of the performance of the two divisions
Market Price Method
May be used if buying and selling divisions can buy/sell
externally at market price.
However, the market price might need to be adjusted
downwards if internal sales incur lower costs than external
sales (e.g. due to lower delivery costs).
Con’t…
Advantages:
Optimal for goal congruence if the selling division is at full
capacity
Encourages efficiency—the supplying division must compete
with external competition
Disadvantages:
Only possible if a perfectly competitive external market exists
Market prices may fluctuate.
Full Cost Plus
The supplying division charges full absorption cost
plus a mark-up.
Standard costs should be used rather than actual to
avoid selling divisions transferring inefficiencies to
buying divisions
Con’t…
Advantages:
Easy to calculate if standard costing system exists
Covers all costs of the selling division.
May approximate to market price
Disadvantages:
The fixed costs of the selling division become the variable costs of the
buying division—may lead to dysfunctional decisions
If the selling division has spare capacity it may lead to dysfunctional
decisions
Mark-up is arbitrary
Variable / Marginal Cost Plus
The supplying division charges variable or marginal cost plus
a mark-up
Advantage
Optimal for goal congruence when:
-the selling division has spare capacity; or
-no external market exists.
Disadvantage
May be difficult to calculate (variable cost is often used as an
approximation)
Incongruent Goal Behaviour
All the practical approaches suffer from the potential problem
that the transfer price may lead to behaviour which is not
congruent with overall firm goals.
The selling division may set a price too high for the buying
division, leading the buying division to buy externally or forgo
production.
Example 4
Company has two profit centres, Centre A and Centre B. Centre A supplies
Centre B with a part-finished product. Centre B completes the production
and sells the finished units in the market at $35 per unit. There is no
external market for Centre A's part-finished product.
Budgeted data for the year:
Division A Division B
Number of units transferred/ sold 10,000 10,000
Material cost per unit $8 $2
Other variable cost per unit $2 $3
Annual fixed costs $60,000 $30,000
Required:
Calculate the budgeted annual profit for each division and for
the company as a whole of the transfer price for the components
supplied by division A to division B if:
(a)Full cost plus 10%
(b)Marginal cost plus 10%
(c)Evaluate both transfer prices from the perspective of each
individual division and from the perspective of the company as a
whole
THE END
PREPARED BY
BOKANG MASELOANE
