Week 9: Transfer Pricing

An issue of performance measurement

in responsibility centres
Topic Objectives

• Understand the issues arising when divisions transfer

products/services
• Understand when the transfer pricing problem arises
• Be able to successfully make the two transfer pricing
decisions
• Be able to determine a suitable transfer price in a number
of different situations

2
What is a Transfer Price?

• Two business units of the same firm involved in the

transfer of a product or service
– Selling (transferring) Division
– Purchasing Division

• A transfer price is:

– An internally set transaction price to account for the transfer of
goods and services between divisions of the same firm

• Transfer price represents

– Revenue of Selling Division
– Cost of Purchasing Division
Why Have Transfer Prices?

• An aid to decision making

– Division managers often need to decide between transferring
internally and selling/purchasing outside
– Transfer prices represent information on revenues and costs
that managers require to make this decision

• Performance evaluation
– Need to measure impact of transfer in $$’s

• To encourage goal/behavioural congruence

– Transfer prices should encourage managers to make the correct
decision for the firm
The Transfer Pricing Problem: An Overview

Raw Material

Outside Outside
Market Market

Mining Processing
Processng Manufg Outside
Division Division
Division Division Market

Transfer Price? Selling Price?

The Transfer Pricing Problem

It is only a problem when the transferring units are responsibility centres (i.e.
revenue; cost; profit; investment centres)
o Managers are given the responsibility to set transfer prices
o Subunits are evaluated on costs and/or revenues
o Subunit interests conflict

Division A Division B
Transfer of Product X

• P&L Statement P&L Statement

• Revenue Revenue
$$ Transfer Price
• Expenses Expenses
• Net Income Net Income
 Why would transfer pricing matter?

Component transferred

Division A: Division B: Product sold

Component cost of $500 Additional cost of $250 SP: $1000

Profit to Div A Profit to Div B

What if the transfer price was $500?

$750?
$650?

Issues to consider:
performance evaluation; facilitation of decision-making;
motivation; goal congruence
Transfer Pricing Decisions

• There are two basic transfer pricing decisions:

– Whether to buy/sell internally or buy/sell in outside market
– At what price to transfer product/service
• Ideally:
– Managers of the two divisions would make these decisions with
the goal of maximising the value of the firm overall
• In reality:
– Often managers make these decisions with the goal of
maximising their division’s performance
• Thus:
– Managers are often in conflict
– Do not necessarily act in the best interests of the firm
Three Views of a Transfer Pricing Problem

• The ‘upstream’ or selling division

• The ‘downstream’ or buying division

• The corporate viewpoint

– Note that inter-divisional revenues and costs from internal
transactions cancel out from the corporate viewpoint
o Thus the transfer price doesn’t matter from the corporate viewpoint
o EXCEPT that the price influences the decision as to whether to
transfer or not (the sourcing decision)
o AND the transfer price can influence factors that will affect the
customer
Opportunity cost approach: ‘General Rule’ from
the corporate viewpoint

• Transfer Price* = Variable Cost + Opportunity Cost

o Opportunity cost relates to capacity
o If spare capacity exists; the opportunity cost is zero
o When opportunities are foregone (outside sales) that
amount is charged in the transfer price
o i.e. If no spare capacity; the opportunity cost = CM
Foregone (sales-VC) …..in other words TP = Market
Price
• *TP in this formula is really the relevant costs for the
transfer pricing decision that is in the best interest of the
company as a whole (it does not represent the TP itself as
this is determined by the policy or mutual negotiation)

10
 Determining Transfer Prices

Transfer Price Alternatives

1. Cost-based transfer prices
• Variable cost; full cost; full cost plus mark-up

2. Market-based transfer prices

3. Negotiated transfer prices

4. Dual-price
Cost-Based Transfer Prices

• Cost-based: Transfer price based on the costs of producing

the products in question

• Used when:
– Market data is not readily available
o often product transferred internally is not identical to product on
general market, or it may be a unique product customised for
internal supply
o Managers’ sourcing autonomy is limited and market price is
deemed inequitable
o i.e. where corporate management dictates that external
purchase of internally-available product is not an option
– Several methods
o variable cost, full cost, full cost plus mark-up
Market-Based Transfer Prices

Market –based
• Transfer is recorded at external market price
• Selling division records a normal sale
• Purchasing division records equivalent of ‘arms-
length’ purchase
• May be some concession for savings from
internal sale (i.e. logistics, commissions etc)
Market-Based Transfer Prices

Market price represents the ‘relevant cost’ of supplying internally if the

supplying (upstream) division has no idle capacity

What has capacity got to do with it?????

Division A
Capacity= 1000 units 600 units at $300 Division B
VC = 200

400
Units What if Division B now requires
at 150 additional units??
$320
Negotiated Transfer Prices

Negotiated transfer price alternative

• Where autonomy is encouraged, managers are generally
required to negotiate among themselves and come to
agreement on a satisfactory transfer price
• Negotiated transfer pricing is:
– Often used to ensure equity between divisions
o Cost used as a starting point
– Sometimes used when market price unavailable or
production costs are unstable
– Managers may work out overall profit to firm of their ‘joint’
product, and share the profit (negotiate to ‘share’ profits
equally)
Dual Transfer Pricing

Dual Transfer Pricing Alternative

• Finding a single transfer price to fit all the requisite
criteria can be difficult
• Consider dual pricing
– Using two separate transfer-pricing methods to price each
inter-divisional transaction
– i.e. selling division and purchasing division record
transactions at different values
– The difference between the two transfer prices is recorded
in a corporate cost account and borne by the company
Appropriate Transfer Prices?

• Depends on:

– availability of a market price

– cost function of selling division and existence of idle capacity
o any opportunity cost associated with internal transfer?
(displacement of outside sales)
– contextual setting
o recurrent or one-off transfer
o magnitude of transfers in the context of overall business volume
for both divisions
o level of pricing and sourcing autonomy/centralisation promoted
by the firm
Appropriate Transfer Prices?

To decide between the alternatives need

to consider whether the transfer price:
– encourages divisions to act in the firm’s
interest
– results in a fair/equitable performance
evaluation
– encourages appropriate resource allocation
– motivates managers
Transfer Pricing in Cost Centres

Transfer pricing questions frequently arise for the

provision of ‘internal services’
– Internal services — i.e. computer services, accounting and
information services, HR etc.— are typically designated
cost centres
– How would the analysis change if these service provider
division were changed from cost centres to profit centres?
Consider the argument for a ‘profit centre’ approach:
– When user divisions pay for services used:
o the service quality and responsiveness to users is enhanced
o services are not ‘overused’
Internal transfers between cost centres

• If service centres are treated as cost centres:

– use cost-based transfer prices and aim for cost
recovery
– i.e. IT departments charge other cost centre units for
IT service costs
– allocating and charging for communication costs such
as phones and other hand-held devices
• What cost?
– full cost; actual cost
Some factors to think about

• Organisational structure
– is the designated structure - cost centre/profit
centre/investment centre - feasible?
• Decentralised decision-making
– is autonomy for division/unit managers to be encouraged or
centralised from head-office?
• Organisational transfer policy
– cost-based; market-based; negotiated; dual?
– sourcing and selling policies for business units?
– whether to take an organisational perspective or business
unit perspective???
 Some factors to think about

1. Market-based transfers:
– not always possible if there is not a market for the transferred
product/service
2. Negotiated transfer price:
– is often perceived to be fair/equitable but can be time–consuming
& outcome biased by managers’ negotiating skills
3. Cost-based transfer prices might result in:
– Upstream division’s revenues being understated, relative to the
market (assuming efficient operations)
– Downstream division's costs being lower than equivalent market
prices for inputs
– Profits reside disproportionately with the downstream division
(recall Purity Steel)
Some factors to think about

• Fixed costs of the upstream division become variable costs of

the downstream division
– Purchasing division might under-price final product
– Provides no incentives for upstream division to manage costs
efficiently
o Can just pass on ‘actual cost’ in the transfer price.
o Could use ‘standard cost’ to overcome this problem

– Provides no incentive for downstream division to look

elsewhere for supply
 Some factors to think about

• Transfer pricing determination can be subject to inaccuracies of

cost allocation processes
– Marginal cost may not always be constant (economies of
scale)
– If a no profit margin situation exists the upstream division may
refuse to undertake the transfer and/or favour outside sales to
transferring internally
– Alternatively, if downstream division is required to undertake
the transfer, rather than buy outside, it may pay more than the
outside market price
o i.e. competitor economies of scale could be higher and cost structure lower
o Should analyse outsourcing potential (and/or core capabilities)