Transfer+pricing

Financial Management (University of South Africa)

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TRANSFER PRICING

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 Transfer pricing - Background
 WHAT IS A TRANSFER PRICE?
Divisions sometimes transfer products and services
between each other. The price charged between the two
divisions is the transfer price.

 WHY IS TRANSFER PRICING IMPORTANT?

 Transfer pricing affects the profit of both the buying and the selling
divisions.
 Performance evaluations might be affected.
 Management decisions are affected.
 Work morale affected.  vs 

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 Transfer pricing - Introduction
 A transfer pricing system can be introduced in organisations
with more than one department/division which require goods
and/or services provided by the other.
 The fundamental objective in setting transfer prices is to
motivate managers to act in the best interests of the overall
company (Goal congruence).
 A transfer pricing system can have a serious impact on the
performance measurement system in place, if performance is
measured based on profitability. This is so as the transfer
price is revenue to the transferring division and cost to the
receiving division.

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 Goal congruence?
 Acting in the best interests of the overall company
 Alignment of goals to achieve an overarching mission.
 The goals of the company’s individual members are in
alignment with the goals of the company

 WHY IS GOAL CONGRUENCE IMPORTANT?

 Ensures frictionless working
 Ensures achievement of company’s strategic objectives
 Ensures motivation of all concerned
 Gives a fair chance for its employees to achieve their personal goals
too (i.e. receive bonuses)

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 Transfer pricing - Benefits
 It can lead to goal congruence by motivating divisional managers to make
decisions which improve divisional profit and improve profit of the organisation as a
whole.
 It can prevent dysfunctional decision making so that the decision taken by
divisional managers are in the best interest of the organization as a whole.
 Transfer prices can be set at the level that enables divisional performance to be
measured commercially.
 Enables separate profit figures for divisions which allows evaluation of performance
of separate divisions
 It should ensure that divisional autonomy is not undermined. A well-run transfer
pricing system helps to ensure that a balance is kept between divisional autonomy
to provide incentives and motivation, and centralised authority to ensure that the
divisions are all working towards the same target, the benefit of the organisation as
whole.
 Makes managers aware of the value that goods and services have for other
divisions of the organisation.

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 Purposes of transfer pricing
1. To provide information that motivates divisional managers to make
good economic decisions.

2. To provide information that is useful for evaluating the managerial and

economic performance of the divisions.

3. To intentionally move profits between divisions or locations.

4. To ensure that divisional autonomy is not undermined (have

freedom to make choices, have independence, have “control”)

Source: Drury

This links with the “controllability principle”!!!

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 Transfer pricing – General rules
 General rules
The minimum transfer price: Incremental cost
plus the opportunity cost of transferring the
item.
Contribution???

Opportunity cost = lost contribution

The maximum transfer price: Market price

minus internal savings, if any.

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 Transfer pricing – General rules
 Market-based transfer prices
 Only applicable in a highly/perfect competitive market
 Minimum transfer price of selling/transferring division = Market price minus internal
savings.

 Marginal cost plus the opportunity cost – where spare capacity exist
 External market for product exist.
 Transferring division has spare capacity
 Minimum transfer price of transferring division = [Total incremental cost (all units to
be transferred) + total opportunity costs (from external sales forfeited)] ÷ total
number of units to be transferred.
 Opportunity cost exists only if there are external sacrificed sales due to
transfer.
 Incremental cost = variable manufacturing costs + any additional costs as a result of
the decision to transfer. (Use relevant decisions principles to determine the inclusion
or exclusion of additional costs).

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Transfer pricing – Buying division

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Transfer pricing – Selling division

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 Transfer pricing – Selling division
If scenario does not fit into diagram (e.g. no spare capacity
and not a perfect market) then always refer back to the
general rules.

 The minimum transfer price: Incremental cost plus

the opportunity cost of transferring the item.

 The maximum transfer price: Market price minus

internal savings, if any.

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 Transfer pricing – Example
Division Glue
Selling price R500
Direct material R200
Direct labour R100
Variable manufacturing R50
External variable selling cost R30

Capacity 1000 units. Currently selling 700 units

Must transfer 400 units to Sticky division.

Required: Determine the minimum transfer price per unit that Glue
will be willing to transfer at to Sticky.

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 Transfer pricing – Example
Determine the minimum transfer price per unit that Glue will be willing to transfer at to
Sticky

 Read the required carefully.

 From whose view point? Seller or buyer?
→ Seller
 Minimum or maximum transfer price?
→ Minimum
 Read the question information carefully. Which option is applicable:
 Perfect market & no spare capacity ?
 External market & spare capacity ?
 No external market ?

→ External market & spare capacity .

Which method ?
→ Minimum transfer price of transferring division = [Total incremental cost (all units to
be transferred) + total opportunity costs (from external sales forfeited)] ÷ total number
of units to be transferred.

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 Transfer pricing – Example
How many units of sales will be forfeited/loss?
Capacity 1 000 units
Selling 700 units
Spare capacity 300 units
Must transfer 400 units
Lost sales 100 units

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 Transfer pricing – Example
Minimum transfer price of transferring division = [Total incremental
cost (all units to be transferred) + total opportunity costs (from external
sales forfeited)] ÷ total number of units to be transferred.

Incremental cost
Direct material R200
Direct labour R100
Variable manufacturing R50
External variable selling cost* R0
Variable cost per unit R350
Total incremental cost (R350 x 400 units) R 140 000

(* irrelevant – only incurred if sold to external customers)

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 Transfer pricing – Example
Minimum transfer price of transferring division = [Total incremental
cost (all units to be transferred) + total opportunity costs (from
external sales forfeited)] ÷ total number of units to be transferred.

Total opportunity costs from 100 units sales forfeited

Selling price R500
Variable cost (R350) [previously calculated]
External variable selling (R30) [incur - sold to external customers]
Opportunity cost per unit R 120

Total opportunity cost R120 x 100 = R12 000

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 Transfer pricing – Example
Minimum transfer price of transferring division =

[Total incremental cost (all units to be transferred)

+ total opportunity costs (from external sales forfeited)]
÷ total number of units to be transferred.

Total incremental cost R 140 000

Total opportunity cost R12 000
Total cost R 152 000
Total number of units to be transferred 400 units
Minimum transfer price (R152 000 / 400) = R380 per unit

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