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Home > Students > ACCAQualificationStudentJourney > Qualificationresources > ACCAQualification > F5PerformanceManagement > Technicalarticles

TRANSFER PRICING
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Transferpricesarealmostinevitablyneededwheneverabusinessisdividedintomorethanone
departmentordivision
Inaccounting,manyamountscanbelegitimatelycalculatedinanumberofdifferentwaysandcanbe
correctlyrepresentedbyanumberofdifferentvalues.Forexample,bothmarginalandtotalabsorption
costcansimultaneouslygivethecorrectcostofproduction,butwhichversionofcostyoushoulduse
dependsonwhatyouaretryingtodo.
Similarly,thebasisonwhichfixedoverheadsareapportionedandabsorbedintoproductioncanradically
changeperceivedprofitability.Thedangeristhatdecisionsareoftenbasedonaccountingfigures,andif
thefiguresthemselvesaresomewhatarbitrary,sotoowillbethedecisionsbasedonthem.Youshould,
therefore,alwaysbecarefulwhenusingaccountinginformation,notjustbecauseinformationcouldhave
beendeliberatelymanipulatedandpresentedinawaywhichmisleads,butalsobecausetheinformation
dependsontheassumptionsandthemethodologyusedtocreateit.Transferpricingprovidesexcellent
examplesofthecoexistenceofalternativelegitimateviews,andillustrateshowtheuseofinappropriate
figurescancreatemisconceptionsandcanleadtowrongdecisions.

WHENTRANSFERPRICESARENEEDED
Transferpricesarealmostinevitablyneededwheneverabusinessisdividedintomorethanone
departmentordivision.Usually,goodsorserviceswillflowbetweenthedivisionsandeachwillreportits
performanceseparately.Theaccountingsystemwillusuallyrecordgoodsorservicesleavingone
departmentandenteringthenext,andsomemonetaryvaluemustbeusedtorecordthis.Thatmonetary
valueisthetransferprice.Thetransferpricenegotiatedbetweenthedivisions,orimposedbyheadoffice,
canhaveaprofound,butperhapsarbitrary,effectonthereportedperformanceandsubsequent
decisionsmade.
Example1
Takethefollowingscenario
showninTable1,inwhich
DivisionAmakes
componentsforacostof
$30,andtheseare
transferredtoDivisionBfor$50.DivisionBbuysthecomponentsinat$50,incursowncostsof$20,and
thensellstooutsidecustomersfor$90.
Asthingsstand,eachdivisionmakesaprofitof$20/unit,anditshouldbeeasytoseethatthegroupwill
makeaprofitof$40/unit.Youcancalculatethiseitherbysimplyaddingthetwodivisionalprofitstogether
($20+$20=$40)orsubtractingbothowncostsfromfinalrevenue($90$30$20=$40).
Youwillappreciatethatforevery$1increaseinthetransferprice,DivisionAwillmake$1moreprofit,
andDivisionBwillmake$1less.Mathematically,thegroupwillmakethesameprofit,butthesechanging
profitscanresultineachdivisionmakingdifferentdecisions,andasaresultofthosedecisions,group
profitsmightbeaffected.
Considertheknockoneffectsthatdifferenttransferpricesanddifferentprofitsmighthaveonthe
divisions:
Performanceevaluation.Thesuccessofeachdivision,whethermeasuredbyreturnoninvestment
(ROI)orresidualincome(RI)willbechanged.Thesemeasuresmightbeinterpretedasindicatingthata
divisionsperformancewasunsatisfactoryandcouldtemptmanagementatheadofficetocloseitdown.
Performancerelatedpay.Ifthereisasystemofperformancerelatedpay,theremunerationof
employeesineachdivisionwillbeaffectedasprofitschange.Iftheyfeelthattheirremunerationis

affectedunfairly,employeesmoralewillbedamaged.
Make/abandon/buyindecisions.Ifthetransferpriceisveryhigh,thereceivingdivisionmightdecide
nottobuyanycomponentsfromthetransferringdivisionbecauseitbecomesimpossibleforittomakea
positivecontribution.Thatdivisionmightdecidetoabandontheproductlineorbuyincheaper
componentsfromoutsidesuppliers.
Motivation.Everyonelikestomakeaprofitandthisambitioncertainlyappliestothedivisionalmanagers.
Ifatransferpricewassuchthatonedivisionfounditimpossibletomakeaprofit,thentheemployeesin
thatdivisionwouldprobablybedemotivated.Incontrast,theotherdivisionwouldhaveaneasyrideasit
wouldmakeprofitseasily,anditwouldnotbemotivatedtoworkmoreefficiently.
Investmentappraisal.Newinvestmentshouldtypicallybeevaluatedusingamethodsuchasnet
presentvalue.However,thecashinflowsarisingfromaninvestmentarealmostcertainlygoingtobe
affectedbythetransferprice,socapitalinvestmentdecisionscandependonthetransferprice.
Taxationandprofitremittance.Ifthedivisionsareindifferentcountries,theprofitsearnedineach
countrywilldependontransferprices.Thiscouldaffecttheoveralltaxburdenofthegroupandcouldalso
affecttheamountofprofitsthatneedtoberemittedtoheadoffice.
Asyoucansee,therefore,transferpricescanhaveaprofoundeffectongroupperformancebecause
theyaffectdivisionalperformance,motivationanddecisionmaking.

THECHARACTERISTICSOFAGOODTRANSFERPRICE
Althoughnoteasytoattainsimultaneously,agoodtransferpriceshould:
Preservedivisionalautonomy:almostinevitably,divisionalisationisaccompaniedbyadegreeof
decentralisationindecisionmakingsothatspecificmanagersandteamsareputinchargeofeach
divisionandmustrunittothebestoftheirability.Divisionalmanagersarethereforelikelytoresentbeing
toldbyheadofficewhichproductstheyshouldmakeandsell.Ideally,divisionsshouldbegivenasimple,
understandableobjectivesuchasmaximisingdivisionalprofit.
Beperceivedasbeingfairforthepurposesofperformanceevaluationandinvestment
decisions.
Permiteachdivisiontomakeaprofit:profitsaremotivatingandallowdivisionalperformancetobe
measuredusingpositiveROIorpositiveRI.
Encouragedivisionstomakedecisionswhichmaximisegroupprofits:thetransferpricewill
achievethisifthedecisionswhichmaximisedivisionalprofitalsohappentomaximisegroupprofitthisis
knownasgoalcongruence.Furthermore,alldivisionsmustwanttodothesamething.Theresnopointin
transferringdivisionsbeingverykeenontransferringoutifthenextdivisiondoesntwanttotransferin.

POSSIBLETRANSFERPRICES
Inthefollowingexamples,assumethatDivisionAcansellonlytoDivisionB,andthatDivisionBsonly
sourceofcomponentsisDivisionA.Example1hasbeenreproducedbutwithcostssplitbetween
variableandfixed.Asomewhatarbitrarytransferpriceof$50hasbeenusedinitiallyandthisallowseach
divisiontomakeaprofitof$20.
Example2
SeeTable2.Thefollowing
rulesontransferpricesare
necessarytogetbothparties
totradewithoneanother:
Forthetransferoutdivision,
thetransferpricemustbegreaterthan(orequalto)themarginalcostofproduction.Thisallowsthe
transferoutdivisiontomakeacontribution(oratleastnotmakeanegativeone).InExample2,the
transferpricemustbenolowerthan$18.Atransferpriceof$19,forexample,wouldnotbeaspopular
withDivisionAaswouldatransferpriceof$50,butatleastitofferstheprospectofcontribution,eventual
breakevenandprofit.
Forthetransferindivision,thetransferinpriceplusitsownmarginalcostsmustbenogreaterthanthe
marginalrevenueearnedfromoutsidesales.Thisallowsthatdivisiontomakeacontribution(oratleast
notmakeanegativeone).InExample2,thetransferpricemustbenohigherthan$80as:
$80(transferinprice)+$10(ownvariablecost)=$90(marginalrevenue)
Usually,thisruleisrestatedtosaythatthetransferpriceshouldbenogreaterthanthenetmarginal
revenueofthereceivingdivision,wherethenetmarginalrevenueismarginalrevenuelessownmarginal
costs.Here,netmarginalrevenues=$80=$90$10.
So,atransferpriceof$50(transferprice$18,$80),assetabove,willworkinsofarasbothpartieswill
finditworthtradingatthatprice.

THEECONOMICTRANSFERPRICERULE
Theeconomictransferpriceruleisasfollows:

Minimum(fixedbytransferringdivision)
Transferpricemarginalcostoftransferoutdivision
And
Maximum(fixedbyreceivingdivision)
Transferpricenetmarginalrevenueoftransferindivision
Aswellaspermittinginterdivisionaltradetohappenatall,thisrulewillalsogivethecorrecteconomic
decisionbecauseifthefinalsellingpriceistoolowforthegrouptomakeapositivecontribution,no
operativetransferpriceisavailable.
So,inExample2,ifthefinalsellingpriceweretofallto$25,thegroupcouldnotmakeacontribution
because$25islessthanthegroupstotalvariablecostsof$18+$10.Thetransferpricethatwould
makebothdivisionstrademustbenolessthan$18(forDivisionA)butnogreaterthan$15(netmarginal
revenueforDivisionB=$25$10),soclearlynoworkabletransferpriceisavailable.
If,however,thefinalsellingpriceweretofallto$29,thegroupcouldmakea$1contributionperunit.A
viabletransferpricehastobeatleast$18(forDivisionA)andnogreaterthan$19(netmarginalrevenue
forDivisionB=$29$10).Atransferpriceof$18.50,say,wouldworkfine.
Therefore,allthatheadofficeneedstodoistoimposeatransferpricewithintheappropriaterange,
confidentthatbothdivisionswillchoosetoactinawaythatmaximisesgroupprofit.Headofficetherefore
giveseachdivisiontheimpressionofmakingautonomousdecisions,butinrealityeachdivisionhasbeen
manipulatedintomakingthechoicesheadofficewants.
Note,however,thatalthoughwehaveestablishedtherangeoftransferpricesthatwouldworkcorrectlyin
termsofeconomicdecisionmaking,thereisstillplentyofscopeforargument,distortionand
dissatisfaction.Example1suggestedatransferpricebetween$18and$80,butexactlywherethe
transferpriceissetinthatrangevastlyalterstheperceivedprofitabilityandperformanceofeachsubunit.
Thehigherthetransferprice,thebetterDivisionAlooksandtheworseDivisionBlooks(andviceversa).
Inaddition,atransferpricerangeasderivedinExample1and2willoftenbedynamic.Itwillkeep
changingasbothvariableproductioncostsandfinalsellingpriceschange,andthiscanbedifficultto
manage.Inpractice,managementwouldoftenprefertohaveasimplertransferpriceruleandamore
stabletransferpricebutthissimplicityrunstheriskofpoorerdecisionsbeingmade.

PRACTICALAPPROACHESTOTRANSFERPRICEFIXING
Inordertoaddresstheseconcerns,somecommonpracticalapproachestotransferpricefixingexist:
1Variablecost
Atransferpricesetequaltothevariablecostofthetransferringdivisionproducesverygoodeconomic
decisions.Ifthetransferpriceis$18,DivisionBsmarginalcostswouldbe$28(eachunitcosts$18tobuy
inthenincursanother$10ofvariablecost).Thegroupsmarginalcostsarealso$28,sotherewillbegoal
congruencebetweenDivisionBswishtomaximiseitsprofitsandthegroupmaximisingitsprofits.If
marginalrevenueexceedsmarginalcostsforDivisionB,itwillalsodosoforthegroup.
Althoughgoodeconomicdecisionsarelikelytoresult,atransferpriceequaltomarginalcosthascertain
drawbacks:
DivisionAwillmakealossasitsfixedcostscannotbecovered.Thisisdemotivating.
Performancemeasurementisdistorted.DivisionAiscondemnedtomakinglosseswhileDivisionBgets
aneasyrideasitisnotchargedenoughtocoverallcostsofmanufacture.Thiseffectcanalsodistort
investmentdecisionsmadeineachdivision.Forexample,DivisionBwillenjoyinflatedcashinflows.
ThereislittleincentiveforDivisionAtobeefficientifallmarginalcostsarecoveredbythetransferprice.
InefficienciesinDivisionAwillbepasseduptoDivisionB.Therefore,ifmarginalcostisgoingtobeused
asatransferprice,atleastmakeitstandardmarginalcost,sothatefficienciesandinefficienciesstay
withinthedivisionsresponsibleforthem.
2Fullcost/fullcost
plus/variablecost
plus/marketprice
Example3.
SeeTable3.
Atransferpricesetatfull
costasshowninTable3(orbetter,fullstandardcost)isslightlymoresatisfactoryforDivisionAasit
meansthatitcanaimtobreakeven.Itsbigdrawback,however,isthatitcanleadtodysfunctional
decisionsbecauseDivisionBcanmakedecisionsthatmaximiseitsprofitsbutwhichwillnotmaximise
groupprofits.Forexample,ifthefinalmarketpricefellto$35,DivisionBwouldnottradebecauseits
marginalcostwouldbe$40(transferinpriceof$30andownmarginalcostsof$10).However,froma
groupperspective,themarginalcostisonly$28($18+$10)andapositivecontributionwouldbemade
evenatasellingpriceofonly$35.Headofficecould,ofcourse,instructDivisionBtotradebutthen
divisionalautonomyiscompromisedandDivisionBmanagerswillresentbeinginstructedtomake
negativecontributionswhichwillimpactontheirreportedperformance.ImagineyouareDivisionBs
manager,tryingyourbesttohitprofittargets,makewisedecisions,andmoveyourdivisionforwardby
carefullyevaluatedcapitalinvestment.
Thefullcostplusapproachwouldincreasethetransferpricebyaddingamarkup.Thiswouldnow

motivateDivisionA,asprofitscanbemadethereandmayalsoallowprofitstobemadebyDivisionB.
However,againthiscanleadtodysfunctionaldecisionsasthefinalsellingpricefalls.
Atransferpricesettothemarketpriceofthetransferredgoods(assumingthatthereisamarketforthe
intermediateproduct)shouldgivebothdivisionstheopportunitytomakeprofits(iftheyoperateatnormal
industryefficiencies),butagainsuchatransferpricerunstheriskofencouragingdysfunctionaldecision
makingasthefinalsellingpricefallstowardsthegroupmarginalcost.However,marketpricehasthe
importantadvantageofprovidinganobjectivetransferpricenotbasedonarbitrarymarkups.Market
priceswillthereforebeperceivedasbeingfairtoeachdivision,andwillalsoallowimportantperformance
evaluationtobecarriedoutbycomparingtheperformanceofeachdivisiontooutside,standalone
businesses.Moreaccurateinvestmentdecisionswillalsobemade.
Thedifficultywithfullcost,fullcostplus,variablecostplus,andmarketpriceisthattheyallresultinfixed
costsandprofitsbeingperceivedasmarginalcostsasgoodsaretransferredtoDivisionB.DivisionB
thereforehasthewrongdatatoenableittomakegoodeconomicdecisionsforthegroupevenifit
wantedto.Infact,onceyougetawayfromatransferpriceequaltothevariablecostinthetransferring
division,thereisalwaystheriskofdysfunctionaldecisionsbeingmadeunlessanupperlimitequaltothe
netmarginalrevenueinthereceivingdivisionisalsoimposed.

VARIATIONSONVARIABLECOST
Therearetwoapproachestotransferpricingwhichtrytopreservetheeconomicinformationinherentin
variablecostswhilepermittingthetransferringdivisiontomakeprofits,andallowingbetterperformance
valuation.However,bothmethodsaresomewhatcomplicated.
Variablecostpluslumpsum.Inthisapproach,transfersaremadeatvariablecost.Then,periodically,
atransferismadebetweenthetwodivisions(CreditDivisionA,DebitDivisionB)toaccountforfixedcosts
andprofit.ItisarguedthatDivisionBhasthecorrectcumulativevariablecostdatatomakegood
decisions,yetthelumpsumtransfersallowthedivisionsultimatelytobetreatedfairlywithrespectto
performancemeasurement.Thesizeoftheperiodictransferwouldbelinkedtothequantityorvalueof
goodstransferred.
Dualpricing.Inthisapproach,DivisionAtransfersoutatcostplusamarkup(perhapsmarketprice),
andDivisionBtransfersinatvariablecost.Therefore,DivisionAcanmakeamotivatingprofit,while
DivisionBhasgoodeconomicdataaboutcumulativegroupvariablecosts.Obviously,thedivisional
currentaccountswontagree,andsomeperiodendadjustmentswillbeneededtoreconcilethoseandto
eliminatefictitiousinterdivisionalprofits.

MARKETSFORTHE
INTERMEDIATE
PRODUCT
ConsiderExample1again,
butthistimeassumethatthe
intermediateproductcanbe
soldto,orboughtfrom,amarketatapriceofeither$40or$60.SeeTable4.
(i)Intermediateproductbought/soldfor$40
DivisionAwouldrathertransfertoDivisionB,becausereceiving$50isbetterthenreceiving$40.Division
Bwouldratherbuyinatthecheaper$40,butthatwouldbebadforthegroupbecausethereisnowa
marginalcosttothegroupof$40insteadofonly$18,thevariablecostofproductioninDivisionA.The
transferpricemust,therefore,competewiththeexternalsupplypriceandmustbenohigherthanthat.It
mustalsostillbenohigherthanthenetmarginalrevenueofDivisionB($90$10=$80)ifDivisionBis
toavoidmakingnegativecontributions.
(ii)Intermediateproductbought/soldfor$60
DivisionBwouldratherbuyfromDivisionA($50beats$60),butDivisionAwouldsellasmuchas
possibleoutsideat$60inpreferencetotransferringtoDivisionBat$50.AssumingDivisionAhadlimited
capacityandalloutputwassoldtotheoutsidemarket,thatwouldforceDivisionBtobuyoutsideandthis
isnotgoodforthegroupasthereisthenamarginalcostof$60whenobtainingtheintermediateproduct,
asopposedtoitbeingmadeinDivisionAfor$18only.Therefore,wemustencourageDivisionAto
supplytoDivisionBandwecandothisbysettingatransferpricethatishighenoughtocompensatefor
thelostcontributionthatDivisionAcouldhavemadebysellingoutside.Therefore,DivisionAhasto
receiveenoughtocoverthevariablecostofproductionplusthelostcontributioncausedbynotselling
outside:
Minimumtransferprice=$18+($60$18)=$60
Basically,thetransferpricemustbeasgoodastheoutsidesellingpricetogetDivisionBtotransfer
insidethegroup.
Thenewrulescanthereforebestatedasfollows:

ECONOMICTRANSFERPRICERULE
Minimum(fixedbytransferringdivision)
Transferpricemarginalcostoftransferoutdivision+anylostcontribution
And

Maximum(fixedbyreceivingdivision)
Transferpricethelowerofnetmarginalrevenueoftransferindivisionandthe
externalpurchaseprice

CONCLUSION
Youmighthavethoughtthattransferpricesweremattersoflittleimportance:debitsinonedivision,
matchingcreditsinanother,butwithnooveralleffectongroupprofitability.Mathematicallythismightbe
thecase,butonlyatthemostelementarylevel.Transferpricesarevitallyimportantwhenmotivation,
decisionmaking,performancemeasurement,andinvestmentdecisionsaretakenintoaccountand
thesearethefactorswhichsooftenseparatesuccessfulfromunsuccessfulbusinesses.
KenGarrettisafreelancewriterandlecturer

Lastupdated:22Sep2014