CHAPTER 8

Transfer Pricing
1 Principles of transfer pricing
What is a transfer price?
A transfer price is the price at which goods or services are transferred from one
profit centre to another within the same organisation..

Objectives of a transfer pricing system

♦ Goal congruence The decisions made by each profit centre manager
should be consistent with the objectives of the organisation as a whole.

♦ Performance appraisal The performance of each responsibility centre

should be capable of being assessed.
♦ Divisional autonomy The system used to set transfer prices should seek
to maintain the autonomy of profit centre managers

2 Transfer pricing with no external market

The receiving division may be selling on a perfect market or an imperfect
market.
♦ A perfect market is one where the receiving division must accept this
market price (because there are many companies in the field and no one
company can dictate to the market).

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♦ An imperfect market is one where the receiving division sets the market
price for the final product (perhaps because there is a monopoly).

Example
A firm manufactures and sells shepherds’ crooks. The company is organised
into two divisions, one of which concentrates on manufacturing the basic crook,
while the other finishes the crook and is responsible for selling and distribution.
The total annual cost and demand functions are as shown below.
Total annual cost in manufacturing division,
CM = 5,000 + 4Q + 0.0001Q2
Total annual cost in selling division,
CS = 10,000 + 8Q + 0.00005Q2
Selling price, PS = 24 – 0.00048Q
All cost and price figures are in pounds and Q denotes annual production and
sales. CS excludes any costs transferred from the manufacturing division.
Required
Calculate the optimal transfer price to maximise overall profitability.

Solution
Profit is maximised when marginal cost and marginal revenue are equal.
Looking at the company overall, the optimal activity level can be found by
equating expressions for marginal revenue and the combined marginal cost of
each division. Notice that the marginal revenue and marginal cost are obtained
by differentiating the revenue and cost functions.

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Selling price PS = 24 – 0.00048Q

Revenue RS = PS x Q = 24Q – 0.00048Q2

dR
Marginal revenue MRS = = 24 – 0.00096Q
dQ

Company’s total cost CC = CM + CS

= 15,000 + 12Q + 0.00015Q2

d (Cc )
Company’s marginal cost MCC = = 12 + 0.0003Q
dQ

Profit is maximised when marginal cost equals marginal revenue, ie when:

24 – 0.00096Q = 12 + 0.0003Q
0.00126Q = 12
Q = 9,524
PS = 24 – 0.00048Q
= £19.43
The company should manufacture 9,524 crooks a year and sell them at £19.43
each.
We now use this to establish a transfer price.
Any transfer price that is fixed represents marginal revenue to the
manufacturing division and additional marginal costs to the selling division. The
price must be set to ensure that each division’s profit is maximised at an activity
level of 9,524 crooks a year.

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The marginal cost in the manufacturing division at a level of 9,524 is found as

follows.

d( C M )
MCM = = 4 + 0.0002Q
dQ

When Q is 9,524, MCM = 4 + 0.0002 x 9,524 = 5.9048

This, therefore, should be the transfer price: £5.90½
The marginal cost in the selling division, excluding the transfer price, is given
by:
MCS = 8 + 0.0001Q
Including the transfer price, this becomes:
Marginal costs = 13.905 + 0.0001Q
It will be seen that by comparing this with the selling division’s marginal
revenue,
MR = 24 – 0.00096Q
the selling division’s profit is maximised when:
13.905 + 0.0001Q = 24 – 0.00096Q

10.095
Q= = 9,524
0.00106
Thus, using a transfer price of £5.90½ per crook, each division’s profit is
maximised at an activity level of 9,524, which is also the optimal activity level for
the company overall.

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3 Transfer pricing with an external market
A perfect market for the intermediate product
The situation we are now considering is illustrated below.

External
market Perfect market
for intermediate
product

Imperfect market
for final product
Intermediate
product
Supplying Receiving
Division Division

To show the effects of this new situation we extend our previous example by
supposing that a perfect market exists for unfinished crooks.
The transfer price will be the same as the market price.
♦ If a transfer price were set above this figure, the second (finishing and
selling) division would not wish to buy from the manufacturing division
but would prefer to buy from outside.
♦ If a transfer price was set below market price, the first (manufacturing)
division would not wish to transfer to the selling division but would prefer
to sell outside.

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An imperfect market for the intermediate product

This situation is illustrated below.
An imperfect market for the intermediate product

External
market Imperfect market
for intermediate
product

Imperfect market
for final product
Intermediate
product
Supplying Receiving
Division Division

The manufacturing division is now faced with a decision as to which of two

markets the unfinished crooks should be sold in.
Suppose unfinished crooks could be sold in a market where the following
demand curve applied:
Selling price, unfinished crooks, PM = 12 – 0.0002Q
It is in the company’s best interests for the manufacturing division either to sell
crooks in the intermediate market or to pass them on to the selling division
according to where marginal revenue (in the case of the selling division, net
marginal revenue) is the greater.
MCM = 4 + 0.0002Q
MRM = 12 – 0.0004Q
NMRS = 16 – 0.00106Q

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Initially the manufacturing division should pass crooks on to the selling division,
but eventually the net marginal revenue from the selling division will fall to £12
(the same as marginal revenue initially in the intermediate market), at a sales
level of 3,774. From then on the manufacturing division should also sell
outside.
Suppose that the manufacturing division produces D units for sale on the
intermediate market and E units to the selling division for conversion into
finished crooks. Profit will be maximised when:
MCM = MRM = NMRS
4 + 0.0002 (D + E) = 12 – 0.0004D = 16 – 0.00106E
Equating the first two and the second two:
4 + 0.0002D + 0.0002E = 12 –
0.0004D
12 – 0.0004D = 16 – 0.00106E
Rearranging:
2E + 6D = 80,000 (1)
10.6E – 4D = 40,000 (2)
Solving simultaneously:
D = 10,726
E = 7,821
C=D+E = 18,547
The optimal transfer price can be found by substituting C, D or E into the
appropriate marginal cost or revenue expression. Using the expression for
marginal cost:

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Optimal transfer price = 4 + (0.0002 x 18,547)

= £7.71

4 Transfer pricing in practice

Transfer prices based on market prices
The market price used for an internal transfer price should be that charged by
the supplier who most accurately reflects the product quality, delivery and other
auxiliary terms and services offered by the internal producer.
It will often happen that a slightly lower price than market price may be used for
internal transfer purposes, to take account of the lower transaction costs
involved.

Outside purchases

Divisional independence involves the freedom for a buying division to make use
of outside sources of supply. This might occur, for example, when owing to
market imperfections, an outside supplier’s price is below that of the internal
supplying division.

If the supplying division had unutilised capacity, it would normally be preferable

to make use of that capacity rather than to purchase from outside. Divisional
autonomy might therefore be overridden by a central directive that purchases
will be made internally whenever the capacity exists.

Transfer prices based on costs

It may happen that there is no open market price for the intermediate product.

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Actual or standard costs?

Unless the intermediate product is a ‘one-off’ customised order, it is best to use

the long-run standard cost as a basis for transfer pricing.

Full or variable costs?

To provide incentive to the supplying division, the transfer price system would
need to give some contribution towards fixed costs and profit. However, if this
is done by setting the transfer price on a full cost plus basis, it may lead to sub-
optimal decisions being taken.

Illustration
Division B sells a final product to outside customers at £14 per unit. It buys an
intermediate product from Division A at £4 per unit and incurs additional
variable processing costs of £10.50 per unit.
The transfer price of £4 from Division A comprises:
Per unit
£
Variable costs 1.50
Fixed costs, absorbed on the basis of budgeted activity 1.20
Profit 1.30
____
Transfer price 4.00
====
Division B thus loses £0.50 on every unit of final product, and will be motivated
either to discontinue the product or to seek an outside alternative supplier to
replace Division A.

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If we look more closely at the figures we find that it is in fact the best course for
the company as a whole for B to continue purchasing from A and selling the
final product.
For the company as a whole, each outside sale yields contribution as follows.
£ £
Final selling price 14.00
Variable costs
Division A 1.50
Division B 10.50
_____
12.00
_____
Contribution towards the company’s fixed costs and 2.00
profit =====

Here, a transfer price has been set which has sent the wrong signals to the
manager of Division B, leading him to act in a way which, although it appears
optimal for his own division, is not optimal for the company as a whole.

Transfer prices based on opportunity cost

An often-quoted method of setting transfer prices is that they should be based
on marginal cost of producing the item transferred plus opportunity cost to the
company of making the transfer.

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