Describe and evaluate the various approaches for setting transfer prices.

How can the use of different appraoches between the selling and buying divisions be reconciled?

Transfer pricing is the practice of setting internal prices within a company at which goods and services can be bought and sold between different divisions. There are four different approaches of setting transfer prices. (Atrill and McLaney 2009 pp 386-396). They are based on: Market prices Negotiated prices Variable cost Full cost The Market Prices approach involves determining the price of the product or service in the external market and adopting that as the internal selling price. This is an ideal approach because the selling division can charge the buying division the opportunity cost of selling to the market. This approach, however, may, at times, be impractical as there may not be an external market price or the existing external price may be uneconomical as a transfer price. For example, in instances when the internal buying division has the option to buy from the open market, the selling division may be forced to set the transfer price at less than the full market price in order to make the internal sale especially if the selling division is operating at full capacity and unable to achieve its budgeted sales. The Negotiated Prices approach sets a transfer price that is negotiated between the selling and the buying divisions. Negotiations would be facilitated if division managers are able to use an external market price as the benchmark price. If not, disputes between divisions may arise. Disputes should be avoided as they risk diverting senior management focus from strategic issues in order to mediate between divisions. Variable Cost approach is the setting of the transfer price based on the variable cost of the product or service. This approach is beneficial to the selling division that is producing below capacity if it sets the transfer price above the variable cost so that it can make a contribution to the profit margin. On the other hand, it is not advantageous to the selling division that is producing at full capacity and its external market is willing to pay above the variable cost because it will not be able to maximize its profit potential. The Full Cost approach involves charging the full cost (variable cost plus overheads) of the product or service to the buying division. This approach is not attractive to either the selling or the buying division. The selling division will miss out on making any profit on the sale unless is able to add a mark up. However, marking up may become a contentious issue if the buying division is already absorbing some of the overheads of the selling division as part of a company-wide overhead sharing policy. Reconciling the different approaches Setting transfer pricing is not easy and deciding on the most appropriate one will rely on properly assessing the prevailing organisational context and operational needs at the time. Atrill and McLaney (2009 p 391) suggests the following options for reconciling the different approaches:

 In the event that transfer pricing based on full cost is considered, a better option to be to base the price on budgeted or actual cost. This preserves the selling divisions opportunity to make profit and rationalizes any overhead sharing by the buying decision. Atrill and McLaney (2009) also suggested the option of setting two standardised transfer prices: a selling price for the selling division and a buying price for the buying division. It should be noted that there is comment in the literature (Zimmerman 1997) that this transfer pricing approach that incorporates the-two price policy is costly to determine and may not always be easy implement in a way that satisfies the division managers. REFERENCES Atrill, P. & McLaney, E. (2009) Management accounting for decision makers. 6th ed. Harlow, England: Financial Times/Prentice Hall Zimmerman (1997) EVA and divisional performance measurement: capturing synergies and other issues Bank of America Journal of Applied Corporate Finance 10 (2), pp. 98109 , [Online] Available from http://www3.interscience.wiley.com.ezproxy.liv.ac.uk/ (Accessed on 18 Dec 2011)