MAF551:

TRANSFER PRICING
IN DECENTRALIZED
ORGANIZATION
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 Transfer pricing
• The internal selling price used when goods and services
are transferred between profit centres and investment
centres in a decentralised organisation
– Revenue for the selling unit and cost for the
buying unit
• Transfer price allows
– the selling unit to earn profit to reflect their effort in
producing the product
– The buying unit to record the cost of the transfer of the
product which will match with the external market.
– Each unit to show profits for their efforts (in the
situation where there is a series of transfers of product
between units)
 Transfer Pricing

The amount charged when one division

sells goods or services to another
division

Batteries

Battery Division Auto Division

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 Transfer Pricing

The transfer price affects the profit measure for

both the selling division and the buying division.

A higher transfer
price for batteries
means . . .

greater
Battery Division profits for the Auto Division
battery division.
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 Transfer Pricing

The transfer price affects the profit measure for

both the selling division and the buying division.

A higher transfer
price for batteries
means . . .

lower profits
Battery Division for the Auto Division
auto division.
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 Transfer pricing
• TP encourages each unit generate profits,
so encourage managers to manage their
units as if it were a stand-alone business.
• The transfer price should
– Result in unit profits that are a reliable
and accurate measure of unit
performance
– Preserve and encourage autonomy
within units
– Encourage goal-congruent behaviour
 Goal Congruence

The
The ideal
ideal transfer
transfer price
price allows
allows
each
each division
division manager
manager to to make
make
decisions
decisions that
that maximize
maximize thethe
company’s
company’s profit,
profit, while
while
attempting
attempting to to maximize
maximize his/her
his/her
own
own division’s
division’s profit.
profit.

13-7
 Transfer pricing methods
• Transfer pricing methods
– Market-based prices
– Cost-plus prices
– Negotiated prices
• Market-based prices
– Need competitive external markets for a
product
• Cost-plus prices
– Where there is no external market price
– Intermediate products have no market outside
the company and are processed further to
become final products
 Transfer pricing methods
• Cost-plus prices
– Standard variable cost plus mark up allows
supplying unit to show a contribution margin
on the transferred product
– Standard absorption cost may lead to
overpricing of products and dysfunctional
decisions
– Standard costs should always be used in
favour of actual costs, to prevent cost
inefficiencies being passed on to buying unit
 Transfer pricing methods
• Negotiated prices
– Market price may form the starting point, and
cost may be the lower boundary

• An important issue in setting the transfer

price is whether or not the supplying unit
has spare capacity

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 General Transfer Pricing Rule
• General transfer pricing rule
– Provides guidance on the appropriate
transfer price
– Represents a minimum transfer price
– May guide unit managers to make goal-
congruent decisions
 General-Transfer-Pricing Rule

Additional outlay Opportunity

cost per unit cost
Transfer per unit to the
price
= incurred by +
Supplying Supplying unit
unit

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 Scenario I: No Excess Capacity
• The Battery Division makes a standard 12-volt
battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
• The Battery division is currently selling 300,000
batteries to outsiders at $40. The Auto Division can
use 100,000 of these batteries in its X-7 model.

What is the appropriate transfer price?

 Scenario I: No Excess Capacity
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

$22 Contribution
Transfer $18 variable
price = cost per battery + lost if outside
sales given up
Transfer
price = $40 per battery

13-14
Scenario I: No Excess Capacity

Auto division can Auto division can

purchase 100,000 purchase 100,000
batteries from an batteries from an
outside supplier outside supplier
for less than $40. for more than $40.

Transfer Transfer
will not $40 will
occur. transfer occur.
price
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Scenario I: No Excess
Capacity
General Rule

When the selling division is

operating at capacity, the
transfer price should be
set at the market price.

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 Scenario II: Excess Capacity
• The Battery Division makes a standard 12-volt battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
• The Battery division is currently selling 150,000
batteries to outsiders at $40. The Auto Division can
use 100,000 of these batteries in its X-7 model. It can
purchase them for $38 from an outside supplier.

What is the appropriate transfer price?

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 Scenario II: Excess Capacity
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

Transfer $18 variable

price = cost per battery + $0

Transfer
price = $18 per battery

13-18
Scenario II: Excess Capacity
General Rule

When the selling division is

operating below capacity, the
minimum transfer price is the
variable cost per unit.
So, the transfer price will be not lower
than $18, and not higher than $38.
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Scenario II: Excess Capacity

Transfer Transfer Transfer

will not will will not
occur occur occur

$18 $38
transfer transfer
price price

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 Transfer pricing under different
scenarios
1. An external market and spare capacity in
the supplying unit
– Where there is spare capacity the transfer
of product, gives the supplying unit
additional profits that it would not otherwise
have
– The two units may negotiate a transfer price
less than the market price to provide an
incentive for the buying unit to purchase
from the supplying unit
 Transfer pricing under different
scenarios
2. An external market and no spare capacity in
the supplying unit
– When there is no spare capacity the
supplying unit, will need to take account of
the opportunity cost of lost profits on sales
due to the transfer
3. External market price and limited capacity in
the supplying unit
– Where capacity is limited, an opportunity cost
needs to be accounted for in the transfer
price
 Transfer pricing under different
scenarios
4. No reliable external market and spare
capacity in the supplying unit
– There is no opportunity cost associated
with the transfer so the transfer price may
be based on cost-plus
5. No reliable external market and no spare
capacity in the supplying unit
– The transfer price will need to account for
opportunity cost on lost sales due to the
transfer
Transfer pricing under different
scenarios
 Setting Transfer Prices
The value placed on transfer goods is
used to make it possible to transfer
goods between divisions while allowing
them to retain their autonomy.

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 Goal Congruence
Conflicts may arise between the company’s
interests and an individual manager’s interests
when transfer-price-based performance
measures are used.

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 Setting Transfer Prices
Conflicts may be resolved by . . .

 Direct intervention by top management.

 Centrally established transfer price
policies.
 Negotiated transfer prices.

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 Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.

You really I just won’t

don’t have any pay $65 for
choice! that part!

13-28
 Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.

Now, here is what the two

of you are going to do.

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Who sets the transfer prices?
– Managers of profit centres and investment centres
may have considerable autonomy in deciding
whether
• to accept or reject orders for goods or services
• to source their materials inside or outside the
organisation
• to set and accept transfer prices
– Direct intervention by corporate (head office)
managers to dictate specific transfer prices may
be inconsistent with the philosophy of
decentralisation
– Corporate management may develop general
policies to govern transfer pricing practices
 Centrally Established
Transfer Prices
As
As aa general
general rule,
rule, aa market
market price-based
price-based
transfer
transfer pricing
pricing policy
policy contains
contains the the following
following
guidelines
guidelines .. .. ..
 The
 The transfer
transfer price
price isis usually
usually set
set at
at aa
discount
discount from
from the
the cost
cost toto acquire
acquire the the item
item
on
on the
the open
open market.
market.
 The
 The selling
selling division
division maymay elect
elect to
to transfer
transfer or
or
to
to continue
continue toto sell
sell to
to the
the outside.
outside.

13-31
 Centrally Established
Transfer Prices
As aa general
AsThe general rule,
rule, a
a market
market price-based
price-based
discount depends on cost savings from
transfer
transfer pricing
pricing policy
selling internally. policy contains
contains
Cost savings may thethe
following
include guidelines
items like
following .. .. ..
transportation.
guidelines
 The
 The transfer
transfer price
price isis usually
usually set
set at
at aa
discount
discount from
from the
the cost
cost toto acquire
acquire the the item
item
on
on the
the open
open market.
market.
 The
 The selling
selling division
division maymay elect
elect to
to transfer
transfer or
or
to
to continue
continue toto sell
sell to
to the
the outside.
outside.

13-32
Negotiating the Transfer Price
AA system
system where
where transfer
transfer prices
prices are
are arrived
arrived at
at
through
through negotiation
negotiation between
between managers
managers of of
buying
buying and
and selling
selling divisions.
divisions.

Much
Much management
management
time
time is
is used
used in
in the
the
negotiation
negotiation process.
process. Negotiated
Negotiated price
price may
may not
not
be
be in
in the
the best
best interest
interest of
of
overall
overall company
company operations.
operations.
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Imperfect Markets
Transfer pricing can be quite complex
when selling and buying divisions
cannot sell and buy all they want in
perfectly competitive markets.

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Cost-Based Transfer Prices
Some companies use the following
measures of cost to establish
transfer prices . . .
– Variable cost
– Full absorption cost
 Beware of treating unit fixed costs as

variable.

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Transfer pricing: the influence of income
taxation
• Transfer pricing is used by many companies to
effectively ‘transfer profits’ between business
units in different countries
• International transfer prices may be influenced
by the different taxation rates and different
regulations across countries
• International tax considerations may influence
the transfer prices that are used for domestic
purposes
• Service firms and not-for-profit organisations
may use transfer pricing when services are
transferred between business units
An International Perspective

Since tax rates and import duties are

different in different countries, companies
have incentives to set transfer prices that
will:
 Increase revenues in low-tax countries.
 Increase costs in high-tax countries.
 Reduce cost of goods transferred to high-
import-duty countries.

13-37
 Transfer pricing and service level
agreements
• Dual-rate transfer pricing uses 2 separate TP to price
each inter-division transaction.
• A service level agreement (SLA) is a contract between
two units within an organisation which
– establishes the nature of the service that will be
provided by one unit to the other
– outlines the responsibilities of each party
– outlines price, quality and timing of service delivery,
performance targets, problem-solving arrangements,
ways in which the agreement can be changed or
terminated
• The price of the service is a transfer price and can be
determined using methods similar to those used for the
transfer of goods
 Behavioral Issues:
Risk Aversion and Incentives
The design of a managerial performance
evaluation system using financial performance
measures involves a trade-off between:
Risks imposed on the
Incentives for the manager because
manager to act in financial performance
the organization’s
And measures are only
interests. partially controlled
by the manager.

13-39
 Goal Congruence and
Internal Control Systems
A well-designed internal control system
includes a set of procedures to prevent
these major lapses in responsible behavior:
– Fraud.
– Corruption.
– Financial Misrepresentation.
– Unauthorized Action.

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 Summary
• Decentralisation coupled with responsibility
accounting may improve access to better
information and skills, more timely decisions,
increase the motivation of unit managers and
increase goal congruence
• Financial performance report can be
structured along responsibility lines and
should reflect the type of accountability
assigned to units and their managers
• The performance of units should be
distinguished from the performance of unit
managers
 Summary (cont.)
• Transfer pricing is used in decentralised
organisations to recognise revenue and costs of
goods and services transferred between units
• Transfer prices may be based on market prices,
costs or may be negotiated
• In a decentralised organisation, it is inconsistent
for corporate management to dictate transfer
prices, but they may set broad policies to
govern practices
• A general transfer pricing rule can provide a
minimum transfer price that may reduce
dysfunctional decisions
 End of Chapter 5
Let’s transfer some of your
capital to me so that my rate
of return will be higher!

13-43