Chapter 8 Transfer Pricing Methods

LEARNING OBJECTIVES 1.      Understand how transfer pricing methods affect the performance of independent units. 2.      Explain the different transfer pricing methods. 3.      Determine the optimal transfer price between the selling division and buying division.

 

 

1.      The Need for Transfer Pricing

1.1       Transfer pricing is used when divisions of an organisation need to charge other divisions of the same organisation for goods and services they provide to them. For example, subsidiary A might make a component that is used as part of a product made by subsidiary B of the same company, but that can also be sold to the external market, including makers of rival products to subsidiary B's product. There will therefore be two sources of revenue for A.
(a)        External sales revenue from sales made to other organisations.
(b)       Internal sales revenue from sales made to other responsibility centres within the same organisation, valued at the transfer price.

1.2	Transfer pricing
	Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the measurement of divisional performance or discouraging overall corporate profit maximisation. Transfer prices should be set at a level which ensures that profits for the organisation as a whole are maximised.

1.3

Criteria of a good transfer pricing policy

There are four specific criteria that a good transfer pricing policy should have: (a)       Provide motivation for divisional managers (b)       Maintain divisional autonomy and independence (c)       Allow divisional performance to be assessed objectively (d)       Ensure the divisional managers make decisions that are in the best interests of the divisions and also of the company as a whole (i.e. goal congruence, which is most important among all).

1.4	General rules                                                                                                    (Dec 09)
	The limits within which transfer prices should fall are as follows. (a)       The minimum. The sum of the supplying division’s marginal cost and opportunity cost of the item transferred. (b)       The maximum. The lowest market price at which the receiving division could purchase the goods or services externally, less any internal cost savings in packaging and delivery.

1.5       The minimum results from the fact that the supplying division will not agree to transfer if the transfer price is less than the marginal cost + opportunity cost of the item transferred (because if it were the division would incur a loss).
1.6       The maximum results from the fact that the receiving division will buy the item at the cheapest price possible.

1.7

Example 1

Division X produces product L at a marginal cost per unit of $100. If a unit is transferred internally to division Y, $25 contribution is foregone on an external sales. The item can be purchased externally for $150. The minimum. Division X will not agree to a transfer price of less than $(100 + 25) = $125 per unit. The maximum. Division Y will not agree to a transfer price in excess of $150.   The difference between the two results ($25) represents the savings from producing internally as opposed to buying externally.

2.      Transfer Pricing Methods

2.1       Market-based approach
(Jun 10)
2.1.1    If an external market price exists for transferred goods, profit centre managers will be aware of the price they could obtain or the price they would have to pay for their goods on the external market, and they would inevitably compare this price with the transfer price.
2.1.2    Advantages:
(a)        Divisional autonomy – In a decentralised company, divisional managers should have the autonomy to make output, selling and buying decisions which appear to be in the best interests of the division's performance. (If every division optimises its performance, the company as a whole must inevitably achieve optimal results.)
(b)       Corporate profit maximization – In most cases where the transfer price is at market price, internal transfers should be expected, because the buying division is likely to benefit from a better quality of service, greater flexibility, and dependability of supply. Both divisions may benefit from cheaper costs of administration, selling and transport. A market price as the transfer price would therefore result in decisions which would be in the best interests of the company or group as a whole.
2.1.3    Disadvantages:
(a)        The market price may be a temporary one, induced by adverse economic conditions, or dumping, or the market price might depend on the volume of output supplied to the external market by the profit centre.
(b)       A transfer price at market value might, under some circumstances, act as a disincentive to use up any spare capacity in the divisions. A price based on incremental cost, in contrast, might provide an incentive to use up the spare resources in order to provide a marginal contribution to profit.
(c)        Many products do not have an equivalent market price so that the price of a similar, but not identical, product might have to be chosen. In such circumstances, the option to sell or buy on the open market does not really exist.
(d)       There might be an imperfect external market for the transferred item, so that if the transferring division tried to sell more externally, it would have to reduce its selling price.

2.2       Cost-based approach

2.2.1    Cost-based approaches to transfer pricing are often used in practice, because in practice the following conditions are common.
(a)        There is no external market for the product that is being transferred.
(b)       Alternatively, although there is an external market it is an imperfect one because the market price is affected by such factors as the amount that the company setting the transfer price supplies to it, or because there is only a limited external demand.
2.2.2    Disadvantages:
(a)        It can lead to bad decisions, for example, they don’t include opportunity costs from lost sales.
(b)       The only division that will show any profit on the transaction is the one that makes the final sale to an outside party.
(c)        It provide no incentive for control of costs unless transfers are made at standard cost.

 

(a)       Total cost plus pricing

2.2.3	Total cost plus pricing
	It involves the determination of the total cost per unit for the supplying division. This cost would include both fixed and variable elements. Such a total cost per unit would then be used to evaluate each unit of product internally transferred.

(b)       Variable cost plus pricing

2.2.4	Variable cost plus pricing
	It entails charging the variable cost (marginal cost) that has been by the supplying division to the receiving division. The problem is that with a transfer price at marginal cost the supplying division does not cover its fixed costs.

2.3       Negotiated transfer pricing

2.3.1	Negotiated transfer pricing
	In some cases transfer prices are negotiated between the managers of the supplying and receiving divisions. Information about the market prices and marginal or full costs often provide an input into these negotiations.

2.3.2    Advantages:
(a)        Encourage the management of the selling division to be more conscious of cost control.
(b)       Benefit the buying division by purchasing the product at a lower cost than that of its competitors.
(c)        Provide the basis for a more realistic measure of divisional performance controllable by the divisional mangers through negotiations.
2.3.3    Disadvantages:
(a)        The agreed transfer price can depend on the negotiating skills and bargaining power of the managers involved, the final outcome may not be close to being optimal.
(b)       They can lead to conflict between divisions and the resolution of such conflicts may require top management to mediate.
(c)        They are time-consuming for the managers involved, particularly where a large number of transactions involved.

2.4       Dual-rate transfer pricing

2.4.1	Dual-rate transfer pricing
	It uses two separate transfer prices for supplying division and receiving division. For example, the supplying division may receive the full cost plus a mark-up on each transaction and the receiving division may be charged at the marginal cost of the transfers.