Transfer Pricing A transfer price is the price charged when one segment of a company provides goods or services to another

segment of the same company. The fundamental objective in setting transfer prices is to motivate the managers to act in the best interests of the overall company. When managers do not act in the best interests of the overall company or even in the best interests of their own division, suboptimization occurs.1 In a decentralized company where the divisional managers are empowered to make decisions as regards how to conduct the operations of their respective departments, transfer pricing is critical. This is usually the case when the performance of such managers are evaluated based on the profitability of their respective divisions. When transfers of goods or services are made, a portion of the revenue of one segment becomes a portion of cost of another, and the price at which transfers are made influences the earnings reported by each profit center. The value of these earnings as a measure of performance depends not only on a managers executive abilities but also on the transfer prices used. The transfer pricing system used can distort any reported profit and make profit a poor guide for evaluating divisional performance. In the end, the cost or price used for the transfer will be used in the calculation of divisional return on capital employed, due to the very nature of the formula.2 Managers are intensely interested in how transfer prices are set because they can have a dramatic effect on the reported profitability of their divisions (and consequently, on their performance evaluation). Three common approaches are used to set transfer prices: 1. Allow the managers involved in the transfer to negotiate their own transfer price. (Negotiated transfer pricing) 2. Set transfer prices at cost using either variable cost or full (absorption) cost. ( Cost-based transfer pricing) 3. Set transfer prices at the market price. (Market-based transfer pricing)1 Other approaches to transfer pricing are also available: 1. Set the transfer prices at cost to manufacture plus a normal profit markup. (Cost-plus transfer pricing) 2. Let central management set the transfer price, which is generally chosen to achieve tax minimization or some other firmwide objective. Neither the buying division nor the selling division controls the transfer price. (Arbitrary transfer pricing) 3. Set transfer prices that strike a balance between the purposes they serve in both the consuming (buying) and producing (selling) division. (Dual transfer pricing) Negotiated Transfer Pricing1 A negotiated transfer price results from discussions between the selling and buying divisions of the same company. Negotiated transfer prices have several important advantages. First, this approach preserves the autonomy of the divisions and is consistent with the spirit of decentralization. Second, the managers of the divisions are likely to have much better information about the potential costs and benefits of the transfer than others in the company. When negotiated transfer prices are used, the managers who are involved in a propose transfer within the company meet to discuss the terms and conditions of the transfer. They may decide not to go through with the transfer, but if they do, they must agree to a transfer price. Generally speaking, we cannot predict the exact transfer price they will agree to. However, we can confidently predict two things: (1) the selling division will agree to the transfer only if its profits increase as a result of the transfer, and (2) the buying division will agree to the transfer only if its profits also increase as a result of the transfer. This may seem obvious, but it is an important point. Clearly, if the transfer price is below the selling divisions cost, the selling division will incur a loss on the transaction and it will refuse to agree to the transfer. Likewise, if the transfer price is set too high, it will be impossible for the buying division to make any profit on the transferred item. For any given proposed transfer, the transfer price has bot a lower limit (determined by the selling division) and an upper limit (determined) by the buying division). The actual transfer price agreed to by the two division managers can fall anywhere between those two limits. These limits determine the range of acceptable transfer prices the range of transfer prices within which the profits of both divisions participating in a transfer would increase. An example will help us understand negotiated transfer prices. Harris & Louder, Ltd., owns fast-food restaurants and snack food and beverage manufacturers in the United Kingdom. One of the restaurants, Pizza Maven serves a variety of beverages along with pizzas. One of the beverages is ginger beer, which is served on tap. Harris & Louder has just purchased a new division, Imperial Beverages, that produces ginger beer. The managing director of Imperial beverages has approached the managing director of Pizza Maven about purchasing Imperial Beverages ginger beer for sale at Pizza Maven restaurants rather than its usual brand of ginger beer. Mangers at Pizza Maven agree that the quality of Imperial Beverages ginger beer is comparable to the quality of their regular brand. It is just a question of price. The basic facts are as follows (the currency in this example is pounds, denoted here as ):

Imperial Beverages: Ginger beer production capacity per month Variable cost per barrel of ginger beer Fixed costs per month Selling price of Imperial Beverages ginger beer on the outside market Pizza Maven: Purchase price of regular brand of ginger beer Monthly consumption of ginger beer

10,000 barrels 8 per barrel 70,000 20 per barrel 18 per barrel 2,000 barrels

The Selling Divisions Lowest Acceptable Transfer Price The selling division, Imperial Beverages, will be interested in a proposed transfer only if its profit increases. Clearly, the transfer price must not fall below the variable cost per barrel of 8. In addition, if Imperial Beverages has insufficient capacity to fill the Pizza Maven order wile supplying its regular customers, then it would have to sacrifice some of its regular sales. Imperial Beverages would expect to be compensated for the contribution margin on these lost sales. In sum, if the transfer has no effect on fixed costs, then from the selling divisions standpoint, the transfer price must cover both the variable costs of producing the transferred units and any opportunity costs from lost sales. Sellers perspective: Transfer price Variable cost per unit + Total contribution margin on lost sales Number of units transferred

The Buying Divisions Highest Acceptable Transfer Price The buying division, Pizza Maven, will be interested in a transfer only if its profit increases. In cases like this where a buying division has an outside supplier, the buying divisions decision is simple. Buy from the inside supplier if the price is less than the price offered by the outside supplier. Purchasers perspective: Transfer price Cost of buying from outside supplier Or, if an outside supplier does not exist: Transfer price Profit to be earned per unit sold (not including the transfer price) We will consider several different hypothetical situations and see what the range of acceptable transfer prices would be in each situation. Selling Division with Idle Capacity Suppose that Imperial Beverages has sufficient idle capacity to satisfy the demand for ginger beer from Pizza Maven without sacrificing sales of ginger beer to its regular customers. To be specific, lets suppose that Imperial Beverages is selling only 7,000 barrels of ginger beer a month on the outside market. That leaves unused capacity of 3,000 barrels a month more than enough to satisfy Pizza Mavens requirement of 2,000 barrels a month. What range of transfer prices, if any, would make both divisions better off with the transfer of 2,000 barrels a month? 1. The selling division, Imperial Beverages will be interested in the transfer only if: Transfer price Variable cost per unit + Total contribution margin on lost sales Number of units transferred

Since Imperial Beverages has ample idle capacity, there are no lost outside sales. And since the variable cost per unit is 8, the lowest acceptable transfer price for the selling division is 8. Transfer price 8 + (20 8)0 2,000

2. The buying division, Pizza Maven, can buy similar ginger beer form an outside vendor for 18. Therefore Pizza Maven would be unwilling to pay more than 18 per barrel for Imperial Beverages ginger beer.

Transfer price Cost of buying from outside supplier = 18 3. Combining the requirements of both the selling division and the buying division, the acceptable range of transfer prices in this situation is: 8 Transfer price 18 Assuming that the mangers understand their own businesses and that they are cooperative, they should be able to agree on a transfer price within this range. Selling Division with No Idle Capacity Suppose that Imperial Beverages has no idle capacity to satisfy the demand for ginger beer from Pizza Maven; it is selling 10,000 barrels of ginger beer a month on the outside market at 20 per barrel. To fill the order from Pizza Maven, Imperial Beverages would have to divert 2,000 barrels from its regular customers. What range of transfer prices, if any, would make both divisions better off transferring the 2,000 barrels within the company? 1. The selling division, Imperial Beverages will be interested in the transfer only if: Transfer price Variable cost per unit + Total contribution margin on lost sales Number of units transferred

Since Imperial Beverages has ample idle capacity, there are no lost outside sales. And since the variable cost per unit is 8, the lowest acceptable transfer price for the selling division is 8. (20 8)2,000 = 8 + (20 8) = 20 2,000 Thus, as far as the selling division is concerned, the transfer price must at least cover the revenue on the lost sales, which is 20 per barrel. This makes sense since the cost of producing the 2,000 barrels is the same whether they are sold on the inside market or on the outside. The only difference is that the selling division loses the revenue of 20 per barrel if it transfers the barrels to Pizza Maven. Transfer price 8 + 2. As before, the buying division, Pizza Maven, would be unwilling to pay more than the 18 per barrel it is already paying for similar ginger beer from its regular supplier. Transfer price Cost of buying from outside supplier = 18 3. Therefore, the selling division would insist on a transfer price of at least 20. But the buying division would refuse any transfer price above 18. It is impossible to satisfy both division managers simultaneously; there can be no agreement on a transfer price and no transfer will take place. Is this good? The answer is yes. From the standpoint of the entire company, the transfer doesnt make sense. Why give up sales of 20 to save costs of 18? Selling Division has Some Idle Capacity Suppose now that Imperial Beverages is selling 9,000 barrels of ginger beer a month on the outside market. Pizza Maven can only sell one kind of ginger beer on tap. It cannot buy 1,000 barrels from Imperial Beverages and 1000 barrels from its regular supplier; it must buy all of its ginger beer from one source. To fill the entire 2,000-barrel a month order from Pizza Maven, Imperial Beverages would have to divert 1,000 barrels from its regular customers who are paying 20 per barrel. The other 1,000 barrels can be made using idle capacity. What range of transfer prices, if any, would make both divisions better off with the transfer of 2,000 barrels within the company? 1. As before, the selling division, Imperial Beverages will insist on a transfer price that at least covers its variable cost and opportunity cost: Transfer price Variable cost per unit + Total contribution margin on lost sales Number of units transferred

Since Imperial Beverages does not have enough idle capacity to fill the entire order for 2,000 barrels, there are lost sales from outside customers. Thus, we have, Transfer price 8 + (20 8)1,000 = 14 2,000

2. As before, the buying division, Pizza Maven, can buy similar ginger beer form an outside vendor for 18. Therefore Pizza Maven would be unwilling to pay more than 18 per barrel for Imperial Beverages ginger beer. Transfer price Cost of buying from outside supplier 18 3. Combining the requirements of both the selling division and the buying division, the acceptable range of transfer prices in this situation is: 14 Transfer price 18 Assuming that the mangers understand their own businesses and that they are cooperative, they should be able to agree on a transfer price within this range. No Outside Supplier If Pizza Maven has no outside supplier for the ginger beer, the highest price the buying division would be willing to pay depends on how much the buying division expects to make on the transferred units excluding the transfer price. If, for example, Pizza Maven expects to earn 30 per barrel of ginger beer after paying its own expenses, then it should be willing to pay up to 30 per barrel to Imperial Beverages. Remember, however, that this assumes Pizza Maven cannot buy ginger beer from other sources. Cost-based Transfer Pricing1 Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. Although the cost approach to setting transfer prices is relatively simple to apply, it has some major defects. First, the use of cost particularly full cost as a transfer price can lead to bad decisions and thus suboptimization. (If the purchase price of the transferred item from outside suppliers is lower than the full cost, but higher than the variable cost, of producing it, the buying division may opt to purchase such item from the outside supplier. However, from the standpoint of the entire company, it is more beneficial to purchase from the selling division as it is practically cheaper.) Second, if cost is used as the transfer price, the selling division will never show a profit on any internal transfer. The only division that shows a profit is the division that makes the final sale to an outside party. (To address this shortcoming, a better performance measure for divisional managers would be their cost saving abilities.) Third, cost-based prices do not provide incentives to control costs. If the actual costs of one division are simply passed on to the next, there is little incentive for anyone to work to reduce costs. This problem can be overcome by using standard costs rather than actual costs for transfer prices. Despite these shortcomings, cost-based transfer prices are commonly used in practice. Advocates argue that they are easily understood and convenient to use. Market-based Transfer Pricing Under this approach, the price charged internally is the selling price of the product to the outside market. This method is the bet profitability and performance measurement because it is objective. It reflects product profitability and divisional management performance, with divisions operating on a competitive basis. It also aids in planning and generally is required by foreign tariff laws and income tax regulations. The most serious drawback to this method is the requirement of a well-developed outside competitive market.2 The market price approach is designed for situations in which there is an outside market for the transferred product or service; the product or service is sold in its present form to outside customers. If the selling division has no idle capacity, the market price is the perfect choice for the transfer price. This is because, from the companys perspective, the real cost of the transfer is the opportunity cost of the lost revenue on the outside sale. Whether the item is transferred internally or sold on the outside market, the production costs are exactly the same. If the market price is used as the transfer price, the selling division manager will not lose anything by making the transfer, and the buying division manager will get the correct signal about how much it really costs the company for the transfer to take place.1 While the market price works beautifully when the selling division has no idle capacity, difficulties occur when the selling division has idle capacity. Recalling once again the ginger beer example, the outside market price for the ginger beer produced by Imperial Beverages is 20 per barrel. However, Pizza Maven can purchase all of the ginger

beer it wants from outside suppliers for 18 per barrel. Why would Pizza Maven ever buy from Imperial Beverages if it is forced to pay Imperial Beverages market price? Managers at Pizza Maven will regard the cost of ginger beer as 20 rather than 8, which is the real cot to the company when the selling division has idle capacity. Consequently, the managers at Pizza Maven will make pricing and other decisions based on an incorrect cost. Cost-plus Transfer Pricing2 This approach includes the cost to manufacture plus a normal profit markup. It is often used when a market price is not available. In a sense, it is a surrogate for a market price. Although a cost-plus price has the virtue of being easy to compute, it is an imperfect price that can lead to distortions in the relative profitability of the selling and buying divisions. A cost-plus transfer price provides no incentive to the selling division to be efficient. On the contrary because the profit markup is often a percentage of cost there is an incentive to inflate cost through arbitrary allocation of common costs and through arbitrary allocation of common costs and through production inefficiency. In addition, cost-plus transfer pricing has the disadvantage of inflating inventories with intracompany profits that must be eliminated from the financial statements and consolidated income tax returns. Arbitrary Transfer Pricing2 Under this approach, the price is simply set by central management. The price is generally chosen to achieve tax minimization or some other firmwide objective. Neither the buying division nor the selling division controls the transfer price. The advantage of this method is that a price can be set that will achieve the objectives deemed most important by central management. Because central management is responsible for the overall performance of the company, transfer prices set by central management should result in divisional actions that enhance firmwide performance. The methods disadvantages, however, far outweigh any advantage. It can defeat the most important purpose of decentralizing profit responsibility making divisional personnel profit conscious. It also severely hampers the autonomy and profit incentive of division managers. Again, because arbitrary transfer prices generally include some markup profit, determining the actual cost of the final products can be difficult, and intracompany profits must be eliminated from inventories for financial statements and consolidated income tax reporting. Dual Transfer Pricing2 The purpose a transfer price serves may differ in the consuming (buying) and producing (selling) division. For example, a consuming division may rely on a transfer price in make-or-buy decisions or in determining a final products sales price based on an estimate of total differential cost. A producing division, on the other hand, many use a transfer price to measure its divisional performance and, accordingly, would argue against any price that does not provide a divisional profit. In such circumstances, a company may find it useful to adopt a dual transfer pricing approach in which: 1. The producing division uses a market-based, cost-plus, negotiated, or arbitrary transfer price in computing its revenue from intracompany sales. 2. The variable costs of the producing division are transferred to the purchasing division, together with an equitable portion of the fixed cost. 3. The total of the divisional profits is greater than for the company as a whole. The profit assigned to the producing division is eliminated when company-wide financial statements are prepared and income taxes are calculated. This approach means that a producing division has a profit inducement to expand sales and production, both externally and internally. Yet, the consuming divisions are not misled. Their costs are the firms actual costs and do not include an artificial profit. Variable costs, as well as fixed costs, should be associated with the purchase to ensure that the consuming division is aware of the total cost implications. Of course, the benefits from a dual transfer pricing approach can be achieved only if the underlying cost data are accurate and reliable. Although the dual transfer pricing method appears to overcome many of the negative incentives inherent in the other transfer pricing methods, it is not commonly used in practice. This lack in use may be due in part to the record-keeping complexity of the method and in part to the difficulty inherent in evaluating the relative performance of the selling and buying divisions when their profits have determined on different bases.

Sources: 1. Garrison, et al. Managerial Accounting, 12/e. USA. 2008. 2. Carter. Cost Accounting, 14/e. USA 2007.