Pricing Decision and Trasfer (Week 7)

Faculty of Management
Bournemouth University Business School

Department of Accounting, Finance & Economics
Week 7 Lectures: Pricing decisions and The

Transfer Pricing Problem
Dr Akanga
www.bournemouth.ac.uk
Learning Outcomes
• Explain the purpose of Transfer pricing

system
• Explain the different transfer pricing methods
• Explain the general transfer pricing rules and
understand the underlying basis for them.
• Explain the economic consequences of
multinational transfer prices.
Fundamental principles
• When a firm buy and sell products to one

another, two decisions must be made:
 Should the company produce the produce
inside the company or but it from an outside
vendor? This is a sourcing decision
 If produced inside, at what price should the
product be transferred between profit centres
(divisions)? This is the transfer pricing
decision
Transfer pricing
• The value assigned to the goods or services sold or

rented (transferred) from one unit of an organization to
another.
• Treatment is the same as a sale to an outside
customer
 Revenue to the selling unit
 Cost to the buying unit
• Because the exchange takes place within the
organization, the firm has considerable discretion in
setting this transfer price.
Transfer pricing
• Because the managers of both the selling

division and the buying division are evaluated
on division profit, not company profit, they
consider the effect of all sales, both internal
and external, on their division, not company
profit.
• The optimal transfer price is the price that
leads both division managers, each acting in
his or her own self-interest, to make decisions
that are in the firm’s best interest.
Determination of Optimal
Transfer Price
• Given the market prices and the costs in the
firm, does firm profit increase?
• Given the transfer price, the intermediate
market prices, and the divisional costs,
does the selling division profit increase?
• Given the transfer price, the final market
prices, and the divisional costs, does the
buying division profit increase?
Purpose of Transfer pricing
• Providing information for making good

economic decisions
• Providing information for evaluating
managerial and economic performance of
divisions
• To prevent conflict of objectives and ensure
that divisional autonomy is nit undermined
• To intentionally move profits between
locations or divisions
Transfer pricing methods
• Market based transfer prices: Sets the transfer price

at the market price or at a small discount from the
market price.
• Market based transfer pricing will induce goal
congruence if the following conditions exist:
 Competent people: managers should be interested in
the long run as well as the short run performance of
their responsibility centre
 Good atmosphere: managers must regard profits as
measured in their income statement as an important
goal.
 Market price: The ideal transfer price is based on

well established normal identical market price for
the product being transferred, a market price
reflecting the same conditions (quality and
quantity) as the product to which the transfer
price applies
 Freedom to source: alternatives for sourcing
should exists and managers be allowed to
choose the alternative that is in their best
interest.
 Full information: Managers must know about the

available alternatives and the relevant costs and
revenues of each alternative
 Negotiation: There must be a smooth working
mechanism that allows managers to negotiate
contracts between each division
• Marginal cost transfer prices: Outlay

cost to selling division plus forgone
contribution to company projects
• Full cost transfer prices: Although the transfer

pricing rule - differential outlay cost to the
selling division plus the opportunity cost of
making the internal transfer to the company -
assumes that the company has a reliable
estimate of differential or variable cost, this is
not always the case. Consequently,
manufacturing firms sometimes use full
absorption cost as the transfer price.
• Cost-plus a mark up transfer prices: We also find

companies using cost-plus transfer pricing based
on either variable costs or full absorption costs.
• Where competitive prices are not available, prices
are set on the basis of cost plus a profit even though
such prices might be complex to calculate and the
results less satisfactory than the market price
• These methods generally apply a normal markup to
costs as a surrogate for market prices when
intermediate market prices are not available.
• Negotiated transfer prices: Managers of the buying and

selling divisions agree on a price
• Standard costs or actual cost: If actual costs are used
as the basis for the transfer, any variances or
inefficiencies in the selling division are passed to the
buying division. The problem of isolating the variances
that have been transferred to the subsequent buying
divisions becomes extremely complex. To promote
responsibility in the selling division and to isolate
variances within divisions, standard costs are generally
used as a basis for transfer pricing in cost-based
systems.
Padre Papers Example
Padre Papers
Wood Division Paper Division
Wood for
Trees Paper
making paper
Padre Papers
Cost and Production Data
Average units produced 100,000

Average units sold 100,000
Variable manufacturing cost per unit £ 20
Variable finishing cost per unit £ 30
Fixed divisional cost (unavoidable) £2,000,000 £4,000,000
Padre Papers – Resources Flow
Wood Paper Division

Wood Division
(buying division)
(selling division)
Variable wood cost = ?
Variable cost = £20
Variable finishing cost = £30
Fixed cost =£2,000,000 Transfer
Fixed cost =£4,000,000
price
Market for wood Market for paper

(intermediate market (final market
Price = ? Price = ?
• The Paper Division is currently

purchasing 100,000 units from an
outside supplier for £50, but would like
to purchase units from the Wood
Division.
Optimal Transfer Price
• There is no intermediate market.

• In this case, the only outlet for the Wood
Division is the Paper Division and the
only source of supply for the Paper
Division is the Wood Division.
• The optimal transfer price is the outlay
cost for producing the goods (generally
the variable costs).
Perfect Intermediate Marked-
Quality Differences
Quality Difference Example
• Grade B wood: £50 internal transfer price
Quality Difference Example
• Grade A wood: £60 internal transfer price
Managers’ Goals versus Firms’
Goals
• Transfer price higher than market:
Buying division will not buy
• Transfer price lower than market: Selling
division will not sell
Multinational Transfer Pricing
• International (or interstate) transfer

pricing can affect tax liabilities, royalties,
and other payments due to different laws
in different countries or states.
• Company incentive:
 Increase profit in low-tax country
 Decrease profit in high-tax country
Dual Transfer Pricing
• A dual transfer pricing system could be

installed to provide the selling division with a
profit but to charge the buying division only for
costs. That is, the buyer could be charged the
cost of the unit, however cost is determined,
and the selling division could be credited for
cost plus some profit allowance. The
difference could be accounted for in a
specialized centralized account.
Segment Reporting
• Companies are required by the

Financial Reporting Council (FRC) to
report certain information about
segments in order to provide a
measure of performance for those
segments that are significant to the
company as a whole.
Segment Reporting
• The following are the principal items that must be

disclosed about each segment:
• Segment revenue, from both internal and external
customers.
• Interest revenue and expense.
• Segment operating profit or loss.
• Identifiable segment assets.
• Depreciation and amortization.
• Capital expenditures.
• Certain specialized items.
Motivational Problems of
Transfer Pricing
• A supplier whose transfers are almost all
internal is usually organized as a cost center.
The center manager is normally held
responsible for costs, not revenues. Hence, the
transfer price does not affect the manager’s
performance measures.
• In companies in which such a supplier is a profit
center, the artificial nature of the transfer price
should be considered when evaluating the
results of that center’s operations.
Recall
• When a firm buy and sell products to one

another, two decisions must be made:
 Should the company produce the produce
inside the company or but it from an outside
vendor? This is a sourcing decision
 If produced inside, at what price should the
product be transferred between profit centres
(divisions)? This is the transfer pricing
decision
Sourcing decision
• In an ideal situation, the buying manager

should be free to make sourcing decisions.
Similarly, the selling manager should be
allowed to sell products in the most
advantageous (profitable) market
• However, such freedom might not be feasible
or might be constrained by corporate policy
Constraints on sourcing
• Limited market: In most cases, markets or buying

or selling might be limited because of;
 The existence of internal capacity might limit the
development of external markets
 Company might produce unique products
therefore limited markets might exist
 If company has invested significantly in facilities, it
is very unlikely that they will use outside markets
except the selling prices outside are similar to the
company’s variable cost
Conflict resolution
• In most cases, transfer prices are not set by a

central committee but negotiated between
divisional managers
• A committee should be put in place to resolve
any conflicts that might arise
• Responsibilities of the committee include:
 Settling transfer pricing disputes
 Reviewing sourcing changes
 Changing the pricing rules where necessary
Conflict resolution
• Arbitration can be conducted in two ways:

 Written submission
 Oral submission
• The arbitrator reviews the submissions are
resolve the issue in any of the following ways:
 Forcing
 Smoothing
 Bargaining
 Problem solving
a nk
T h
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yo
Reading List
• Chapter 20; Drury, C. (2015), Management &

Cost Accounting, 9th Edition

Pricing Decision and Trasfer (Week 7)

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Faculty of Management

Bournemouth University Business School

Week 7 Lectures: Pricing decisions and The

• Explain the purpose of Transfer pricing

• When a firm buy and sell products to one

• The value assigned to the goods or services sold or

• Because the managers of both the selling

• Providing information for making good

• Market based transfer prices: Sets the transfer price

 Market price: The ideal transfer price is based on

 Full information: Managers must know about the

• Marginal cost transfer prices: Outlay

• Full cost transfer prices: Although the transfer

• Cost-plus a mark up transfer prices: We also find

• Negotiated transfer prices: Managers of the buying and

Wood Division Paper Division

Average units produced 100,000

Padre Papers – Resources Flow

Wood Paper Division

Market for wood Market for paper

• The Paper Division is currently

• There is no intermediate market.

• Grade B wood: £50 internal transfer price

• Grade A wood: £60 internal transfer price

• International (or interstate) transfer

• A dual transfer pricing system could be

• Companies are required by the

• The following are the principal items that must be

• When a firm buy and sell products to one

• In an ideal situation, the buying manager

• Limited market: In most cases, markets or buying

• In most cases, transfer prices are not set by a

• Arbitration can be conducted in two ways:

• Chapter 20; Drury, C. (2015), Management &

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