18 MANAGEMENT DECISION 28,3

I
nternal transfer pricing can be an area There are broadly four alternative pricing policies:
fraught with difficulty.
(1) Cost price
(2) Cost plus a profit
(3) Market price, and
(4) Dual pricing

(1) Cost Price

Transfer The term "cost" must be clearly defined, e.g. is it to be

total or full cost including all overheads, variable or marginal
costs only, or standard cost? Total cost will ensure that

Pricing — the transfer or selling department will recover all costs so

that no loss on transfer is incurred. However, any inefficien-
cies of the transferor will result in a higher cost to the
transferee, or purchasing department automatically lowering

Choice profits, or a reduction of sales if the selling price is raised.

Standard cost ensures that total cost is recovered at

standard but no inefficiencies are transferred. The
disclosure and isolation of adverse variances at the transfer
Albert Galway point will provide an incentive to the transferor department
to improve or maintain efficiency, so both transferor and
transferee benefit by this method.

Variable cost results in a loss to the transferor department

Transfer Pricing
The concept of transfer pricing is that, within a
manufacturing company, one department, on transferring
its output to another department, should regard this
transfer as a sale and that there should be a definite policy
on the setting of the selling price.
Past practice, giving recognition to the idea of a price on
transfer tended to be very arbitrary, a frequently used
method being cost plus a "percentage for contingencies".
The percentage, however, was not always carefully enough
considered and sometimes its effect on the overall selling
price of a product could be damaging to the sales potential
of the producer. For example, the selling price of a cotton
bed sheet might be arrived at after the following
manufacturing processes and transfers. Preparing raw
material, cost + 10 per cent.
Transferred to spinning, yarn cost + 10 per cent
Transferred to weaving, cloth cost + 10 per cent
Transferred to making up, cost + 10 per cent
Transferred to warehouse, cost + 10 per cent
Transferred to retail, selling price.
The cumulative effect of four additions of 10 per cent plus
an eventual profit margin on sales could over-price the
product and turn away potential customers. More recently,
careful consideration of the problems and effects of
transfer pricing has resulted in a more definite choice of
policy.
equal to the fixed costs of that department, but the
transferee will benefit from a lower transfer cost. The fixed
costs of the whole company still have to be recovered and
no incentive is provided by this method.
(2) Cost plus a Profit
This method is similar to (1), i.e. cost must be defined, but
the transferor department will now obtain a profit on transfers
at total or standard cost and recover some or all of its fixed
costs in the variable cost plus profit transfer price.
The transferee or purchasing department must absorb this
profit into its own process costs, and mayfindit difficult
to make its own profit on transfer. The same problems
of inefficiencies and the same dangers of reduced sales
through increased selling prices apply with this method,
while the inclusion of a profit may even lower the incentive
to the transferor department to maintain efficiency. For
these reasons it is vital that the level of profit addition
is carefully considered if the cost plus policy is adopted.
Methods (1) and (2) may be necessary because the
transferor department is the only source of supply for the
product, but where the same product can be purchased
on the open market an alternative pricing method is
presented in (3).
(3) Market Price
When this method of transfer pricing is adopted the
transferor department is in direct competition with outside
suppliers. There is thus an immediate incentive to maintain

or improve efficiency within the transferor department.
If this department can improve on the outside market
price, the difference will be additional profit, while the
transferee department is in no worse a position than if
it were buying in the open market. Indeed the buying
department may obtain benefits, such as better quality
of the product, a steady supply of quantities on demand,
and assured delivery on request with little or no delivery
charges. These benefits will thus improve its profit
potential. By regular checks on market price both
transferor and transferee are aware of the competition in
the field of prices leading to better control within each
department.
(4) Dual Pricing
With a policy of dual pricing the transferor department
can be allowed to sell at a high transfer price while the
transferee is allowed a lower price. This policy may be
suitable in situations where the departments have a choice
of buying and selling both within and outside the company.
This can give a benefit to the divisions but the organisation
as a whole does not gain. The disadvantage of this policy
is that product division managers may not have sufficient
incentive regarding cost and control in their own
departments so that management behaviour in a dual
pricing situation is important.
Transfer Pricing Policy and Management
Behaviour
Company policy on any matter must be clearly defined
and communicated so as to avoid misinterpretation. With
transfer pricing, even the correct interpretation of a clear
policy may give rise to management discontent and
behavioural problems. An example is where a
manufacturing company may have a purchase and selling
practice for its four product divisions, as follows:
Product division Purchases Sells
1 Outside Outside
2 Within Outside
3 Outside Within
4 Within Within
Product division 1 appears to have complete autonomy
over its purchases and sales pricing decisions as it can
buy in the most economical market and sell at its own
price. There is therefore an incentive to efficiency and
maximisation of profits.
Product division 2 must accept a purchase price which
may affect its selling efficiency and profitability.
TRANSFER PRICING - CHOICE 19
Product division 3 purchases in the open market and sells
to a company division using one of the company transfer
pricing methods in accordance with current policy. This
may affect profitability depending on the pricing method.
Product division 4 purchases within the company and sells
to another company division. It is thus restricted to
company pricing policy in both transactions.
There may be good reasons for the policy and practice in
this example but divisional managers may feel constrained
by having to apply a pricing system imposed on them. Some
may experience no incentive to improve their own
departmental efficiency and they may feel resentful
regarding the pricing methods allowed in other departments.
Transfer Pricing Team or Committee
In order to avoid any possible unfavourable reaction by
managers the following arrangements could be implemented:
(1) A transfer pricing team or committee could be set
up.
(2) Members would comprise the departmental
product managers together with the general
manager, management accountant, sales or market
research manager etc, since only top management
may be in a position to assess the opportunity costs
involved in transfer pricing decisions.
(3) The general manager or managing director, acting
as chairman, would control the discussion.
(4) Decisions should reflect the corporate objectives
of the company and co-ordinate the activities of all
departments.
(5) Fair treatment should be ensured for each product
department through full consultation among the
managers to reach an agreed transfer pricing policy.
(6) If departmental profitability is regarded as a
measure of management effectiveness then due
attention must be paid to the effect of the transfer
pricing policy in operation.
The objectives of transfer pricing may be stated as follows:
(1) To encourage the producing department by covering
costs and perhaps showing a profit.
(2) To encourage the buying department by enabling
low cost purchases to be made.
(3) To provide a basis for management incentive
schemes based on profitability of departments.
(4) To provide autonomy to each department. This is
not to make departments self-contained but to avoid
one becoming totally dependent on another.
(5) The major objective may be said to be the
achievement of goal congruence so that the
managerial effort of all departments is concentrated
towards the corporate objectives of the company.
 20 MANAGEMENT DECISION 28,3

TABLEI.Summary of Effects of Transfer Pricing Methods

Transfer price Transferor selling department Transferee purchasing department

Total cost No profit or loss, therefore no incentive to Inefficiencies of transferor may reduce profits
improve efficiency
Standard cost No profit or loss Inefficiencies not passed on in standard cost
Variable cost Loss of fixed costs which have to be Lower price may create profit on transfer but
recovered by company fixed costs still to be borne

Total cost plus Profit earned on transfer Higher transfer price may reduce profit on
transfer or may reduce sales potential
Standard cost plus Profit earned Possible reduced profit or sales potential but
no inefficiencies transferred
Variable cost plus Profit may help absorb fixed costs Lower transfer price butfixedcosts still to be
borne
Cost or cost plus methods applied to transfers between departments within a manufacturing group tend to insulate these
departments from competition in the open market, and may create a disincentive to control costs.

Market price Incentive to improve efficiency and thus Price no higher than outside market therefore
company profitability incentive to work for own profit

Dual pricing Profitability of either transferor or transferee department may be assisted, but the company
may not benefit.

Conclusion tralisation. There is rarely a single transfer price for all needs.
Where a fair open market price is available this should A multinational organisation may find that its overall objectives
be used as the transfer price for inter-departmental are best served by the use of a number of transfer pricing
transactions where practicable. methods to meet the different conditions of structures,
countries and environments in which it operates.
It is worth noting that the National Association of
Accountants of America recommend: Example
Division X and Division Y are manufacturing divisions of a
Internal procurement is expected when the company's
products and services are superior or equal in design, quality, company. Each division makes a single product, X makes pro-
performance, price, and when acceptable delivery schedules duct P and Y makes product Q. As part of its assembly, a unit
can be met. So long as these conditions are met, the of product Q requires one unit of product P which is normally
receiving unit suffers no loss and the supplying unit's profit purchased from Division X at the outside selling price.
accrues to the company.
Details of selling prices and costs are as follows:
Where there is no open market price the method chosen
should be agreed in committee with arbitration if
necessary. Whatever method is applied there must be Product P Product Q
clear demonstration, in the case of international trading, £ £
Selling price 40 60
that no currency or profit manipulation is involved and that Variable costs
the system is not being used for tax evasion purposes. Transferred from X 40
Direct materials 10 6
In establishing the policy on transfer pricing the company Direct labour 6 3
must therefore take into consideration whether the effects Variable overhead 4 1
of such policy on management behaviour will assist or hinder 20 50
the achievement of goal congruence within the management Divisional fixed costs A' £500,000
team. A policy imposed on management without consultation Y £200,000
will be resented, whereas a participative agreement will be Annual sales demand
more readily accepted. Whether functional departments are (outside market) 70,000 25,000 units
regarded as cost centres or profit centres will also affect Division plant capacity 100,000 30,000 units
Investment in division £5,000,000 £1,000,000
management acceptance of the policy.

The evaluation of departmental performance will in a transfer Y division is showing a very low rate of return and its
pricing situation be more consistent with the ideas of decen- manager claims that the high transfer price of product P
 TRANSFER PRICING – CHOICE 21

is the cause of this. The manager of X says that the transfer (iii) This has reversed the results to indicate that
price is fair since it accords with the market price. Division Y is now performing much better than
Division X. Management co-operation would be
Y division manager also states that a proposal for increasing encouraged by establishing a transfer price
the market for product Q by 5,000 units at the existing price somewhere between these extremes, e.g. transfer
is under consideration at an estimated fixed costs increase price of p = £33 giving contribution of £13. Results
of £50,000 per annum, but insists that the transfer price would be as follows:
should be reduced.
It is required to:
(1) Calculate the results under the current transfer price Division X Division Y
arrangements. Product P Product Q
(2) Show how a reduced transfer price would affect the
Increased by External Internal
rates of return.
5,000 units
(3) Calculate the results of the increased sales of product Sales demand 70,000 30,000 30,000
Q using an alternative transfer price arrangement Contribution per
which would be more acceptable to both managers. unit £20 £13 £17
Total contribution £1,790,000 £510,000
Solution
Fixed costs £500,000 £250,000
(i) Results as per current arrangement
Net profit £1,290,000 £260,000
Division X Division Y Rate of return £1,290,000 £260,000
Product P Product Q
£5,000,000 £1,000,000
Sales demand 95,000 25,000 25.8% 26%
Contribution per unit £20 £10 =
Total contribution £1,900,000 £250,000 The additional 5,000 units of product Q will attract 5,000 x £60
Fixed costs £500,000 £200,000
= Sales Revenue £300,000
Net profit £1,400,000 £50,000
Variable costs Div X Product P £20
Rate of return £1,400,000 £50,000
Variable costs Div Y Product Q £10 £
£5,000,000 £1,000,000 Total Variable Costs 5,000 x 30
28% 5% 150,000
Incremental Contribution 150,000
(ii) It would appear that the manager Y is correct in his Increased Fixed Cost 50,000
claim that the transfer price of product Q is too high.
If we alter the price on transfer to a variable cost of Increased Net Profit £100,000
£20 the results are shown below:

Division X Division Y
Product P Product Q If these additional units are sold under the transfer price
arrangements described above, the increased profits would
External Internal be attributed to:
Sales demand 70,000 25,000 25,000
Contribution per
unit £20 £nil £30 Under price Profits to
Total contribution £1,400,000 £750,000 arrangement
Fixed costs £500,000 £200,000
(i) Division X Product P
£900,000 £550,000
Net profit (ii) Division Y Product Q
£900,000 £550,000
(III) Shared Division X £65,000
£5,000,000 £1,000,000 Shared Division Y £35,000
Rate of return 18% 55%
£100,000

Albert Galway is at the Department of Accounting and Finance, University of Ulster at Jordanstown, Northern Ireland.