Transfer Pricing

• In decentralized organizations, the output of one

division is used as the input of another
– The value of the transferred good is revenue to
the selling division and cost to the buying
division
• This value, or internal price, is called the transfer
price
– Transfer price is the price charged for a
component by the selling division to the buying
division of the same company
Impact of Transfer Pricing on Divisions and the Firm as a Whole

• When one division of a company sells to

another division, both divisions as well as
the company as a whole are affected
• The price charged for the transferred good
affects both
– the costs of the buying division
– the revenues of the selling division
• Thus, the profits of both divisions, as well as
the evaluation and compensation of their
managers, are affected by the transfer price
Impact of Transfer Pricing on Divisions and the Firm as a Whole

• Since profit-based performance measures

of the two divisions are affected, transfer
pricing often can be an emotionally
charged issue
• The next exhibit illustrates the effect of the
transfer price on two divisions of a
company
• The selling division typically wants the
transfer price to be as high as possible
while the buying division prefers the
transfer price to be as low as possible
Transfer Pricing Policies: Market Price

• Several transfer pricing policies are

used in practice, including:
– market price
– cost-based transfer prices
– negotiated transfer prices
 Transfer Pricing Policies: Market Price

• If there is a competitive outside market for

the transferred product, then the best transfer
price is the market price
• Divisional managers’ actions will
simultaneously optimize divisional profits and
firmwide profits
• No division can benefit at the expense of
another. In this setting, top management will
not be tempted to intervene
• The market price, if available, is the best
approach to transfer pricing
Transfer Pricing Policies: Cost-Based Transfer Prices

• Frequently, there is no good outside market

price
• The lack of a market price occurs because
the transferred product uses patented
designs owned by the parent company
• A company might use a cost-based transfer
pricing approach
• A transfer price at cost does not allow for any
profit for the selling division
• Top management may define cost as “cost
plus,” which allows a certain percentage to be
tacked onto the cost
Transfer Pricing Policies: Cost-Based Transfer Prices

• Top management may allow the selling and

buying division managers to negotiate a
transfer price
• This approach is useful in cases with market
imperfections, such as an in-house division’s
ability to avoid selling and distribution costs
that external market participants would have
to incur
• Using a negotiated transfer price then allows
the two divisions to share any cost savings
resulting from avoided costs
Negotiated Transfer Prices: Bargaining Range
• When using negotiated transfer prices, a
bargaining range exists
– Minimum Transfer Price (Floor): The transfer
price that would leave the selling division no
worse off if the good were sold to an internal
division than if the good were sold to an
external party
• This is the “floor” of the bargaining
range
– Maximum Transfer Price (Ceiling): The
transfer price that would leave the buying
division no worse off if an input were
purchased from an internal division than if
the same good were purchased externally
• This is the ‘‘ceiling’’ of the bargaining
range
Example: How to Calculate Transfer Price

Omni Inc. has a number of divisions, including Alpha Division, a producer of

circuit boards, and Delta Division, a heating and air-conditioning
manufacturer. Alpha Division produces the cb-117 model that can be used by
Delta Division in the production of thermostats that regulate heating and air-
conditioning systems. The market price of the cb-117 is P700, and the full
cost of the circuit board is P450.
Required:
1. If Omni has a transfer pricing policy that requires transfer at full cost,
what will the transfer price be? Would the Alpha and Delta divisions
choose to transfer at that price?
Example: How to Calculate Transfer Price

2. If Omni has a transfer pricing policy that requires transfer at market

price, what would the transfer price be? Would the Alpha and Delta
divisions choose to transfer at that price?
3. Assume Omni allows negotiated transfer pricing and Alpha Division can
avoid P150 of selling expense by selling to Delta Division. Which
division sets the minimum transfer price, and what is it? Which division
sets the maximum transfer price, and what is it? Would the Alpha and
Delta divisions choose to transfer somewhere in the bargaining range?
Example: How to Calculate Transfer Price

Solution:
1. The full cost transfer price is P450. Delta Division would be delighted
with that price, but Alpha Division would refuse to transfer, since P700
could be earned in the outside market.
2. The market price is P700. Both Delta and Alpha divisions would transfer
at that price (since neither would be worse off than if it bought/sold in
the outside market).
3. Minimum transfer price = P700 – P150 = P550. This price is set by
Alpha, the selling division.
Example: How to Calculate Transfer Price

Maximum transfer price = P700. This price is the market price and is set by
Delta, the buying division.

Both divisions would accept a transfer price within the bargaining range.
Precisely what the transfer price would be depends on the negotiating skills
of the division managers.