Transfer Pricing3

Chapter 25
Pricing Decisions,
Including Target Costing
and Transfer Pricing
Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University
Learning Objectives
1. Identify the objectives and rules used

to establish prices of goods and
services, and relate pricing issues to
the management cycle.
2. Describe economic pricing concepts
including the auction-based pricing
method used on the Internet.
3. Use cost-based pricing methods to
develop prices.
Copyright © Houghton Mifflin Company. All rights reserved. 25–2

Learning Objectives (cont’d)
1. Describe target costing and use that

concept to analyze pricing decisions
and evaluate a new product
opportunity.
2. Describe how transfer pricing is used
for transferring goods and services
and evaluating performance within a
division or segment.

The Pricing Decision and the Manager
• Objective 1
– Identify the objectives and rules used to
establish prices of goods and services, and
relate pricing issues to the management
cycle

• There are many approaches to setting

prices
– Each may produce a different price for the
same product or service
– Is more of an art than a science
• Depends on the manager’s ability to
– Analyze the marketplace
– Anticipate customers’ reactions to a product or
service and its price

(cont’d)
• Factors to consider when analyzing the

market
– Competitors’ price strategies
– Economic environment
– Legal, political, and niche issues
Managers perfect the art of price setting through experience in

dealing with customers and products within their company’s industry

The Objectives of a Pricing Policy
• Setting appropriate prices

– One of a manager’s most difficult day-to-
day decisions
• Affects long-term survival of any profit-oriented
enterprise

The Objectives of a Pricing Policy (cont’d)
• Companies use pricing policies to

differentiate
– Themselves from their competitors
– Among their own brands
• For each product brand, the company
– Identifies the market segment it intends to serve
– Develops pricing objectives to meet the needs of that
market

• Possible objectives of a pricing policy include

1. Identifying and adhering to both short-run and
long-run pricing strategies
2. Maximizing profits
3. Maintaining or gaining market share
4. Setting socially responsible prices
5. Maintaining a minimum rate of return on
investment
6. Being customer focused

• Pricing strategies
– Standard items or commodities for a
competitive market
• Can reduce prices to win sales away from
competitors
• Can continuously add value-enhancing features
and upgrades to products and services
– Creates the impression that customers are receiving
more for their money
– Custom-designed items
• Can be more conservative in pricing strategies

• Underlying objective of pricing policies

– Maximizing profits
– Key lead indicator of profit potential is
increasing market share
• Maintaining or gaining market share is closely
related to pricing strategies
• Market share is important only if sales are
profitable

• Socially responsible pricing

– Enhances a company’s standing with the
public
• Helps ensure long-term survival
• Social concerns include
– Environmental factors
– Influence of an aging population
– Legal constraints
– Ethical issues

• Maintain a minimum rate of return on

investment
– Organizations view each product or service
as an investment
• Must provide a minimum return in order to
invest in making or providing the product or
service
– When setting prices, a markup percentage is added
to the cost of production
– Markup percentage is closely related to objective of
profit maximization

• Important, when setting prices to

– Take customers’ needs into consideration
– Increase a product’s value to customers
• Sensitivity to customer needs is necessary to
sustain growth
• Customers’ acceptance is crucial to success in
a competitive market
• Prices should reflect the enhanced value the
company adds (prices are customer driven)

Pricing and the Management Cycle
• To stay in business, an organization’s

selling price must
1. Be competitive
2. Be acceptable to customers
3. Recover all costs incurred to bring the
product or service to market
4. Return a profit

• Any deviation must be for a specific

short-run objective that accounts for the
change
• Breaking these rules for a long period
will force a company into bankruptcy
– Addressing pricing issues at each stage of
the management cycle helps prevent this
from happening


• Planning phase
– Managers must
• Consider how much to charge for each product
or service by identifying the
– Maximum price the market will accept
– Minimum price the company can sustain
» Those prices form the foundation for budgets
and projections of profitability

• Executing phase
– Products’ or services’ pricing strategies are
followed
– Products or services are sold either at
specified prices or on the auction market

• Reviewing phase
– Managers evaluate sales to determine
which pricing strategies were successful
and which failed
• Important to determine reasons for success or
failure
• Plan corrective action

• Reporting phase
– Internal reports prepared
• Analyses of actual prices and profits versus
targeted profits
• Used to assess past pricing strategies and plan
future strategies

• When making and evaluating pricing

decisions, managers must consider
– The external market
• Demand for the product
• Customer needs
• Competition
• Quantity and quality of competing products
– Internal factors
• Constraints caused by costs
• Desired return on investment
• Quality and quantity of materials and labor
• Allocation of scarce resources

Discussion
A. What are the four rules for setting a

selling price?
A. The selling price must
1. Be competitive with the competition's price
2. Be acceptable to customers
3. Recover all costs incurred in bringing the
product or service to market
4. Return a profit

Economic Pricing Concepts
• Objective 2
– Describe economic pricing concepts
including the auction-based pricing method
used on the Internet

Economic Pricing Concepts
• Economic approach to pricing

– Based on microeconomic theory
• Profit will be maximized when the difference
between total revenue and total costs is the
greatest

Total Revenue and Total Cost Curves
• It may seem that if a company could

produce an infinite number of products,
it would realize the maximum profit
– This is not the case
– Microeconomic theory explains why

Microeconomic Pricing Theory:
Total Revenue and Total Cost Curves

Total Revenue and Total Cost Curves (cont’d)
• Total revenue curve

– Curved line on economist’s breakeven
chart
– Increases as more units are sold, but rate
of increase will diminish
• Theory behind this
– As product is marketed, price reductions will be
necessary to sell additional units because of
competition and other factors

• Total cost curve

– Costs react in opposite way
– Total costs per unit rise at an accelerated
rate as more units are sold
• Theory behind this
– As more units are sold, fixed costs will change
» Supervision and depreciation increase
» Marketing costs rise due to competition

• Breakeven point
– Point where total revenue and total cost curves
intersect
– Two breakeven points in microeconomic pricing
theory
• Area between these two breakeven points represents
profit
• Maximizing profit
– Occurs at point where the difference between total
revenue and total cost is the greatest
• In Figure 3A, this point is 6,000 units of sales

Marginal Revenue and Marginal Cost Curves
• Marginal revenue
– The change in total revenue caused by a one-unit
change in output
• Marginal cost
– The change in total cost caused by a one-unit
change in output
• Marginal revenue and marginal cost are used

by economists to help determine the optimal
price for a good or service

(cont’d)
• Graphic curves for marginal revenue

and marginal cost
– Created by measuring and plotting the rate
of change in total revenue and total cost at
various activity levels
– Profit per unit greatest where marginal
revenue and marginal cost curves intersect
• Projecting this point onto the product’s demand
curve locates the optimal price

Microeconomic Pricing Theory:

(cont’d)
• Information used in microeconomic

theory analyses relies on projected
amounts for unit sales, product costs,
and revenues
– But, usually highlights cost patterns and
the unanticipated influences of demand
– Should also rely on other data when setting
product prices

Auction-Based Pricing
• Occurs two ways

1. Seller auction-based price
– Sellers post what they have to sell, ask for
price bids, and accept a buyer’s offer to
purchase at a certain price
2. Buyer auction-based price
– Buyers post what they want, ask for prices,
and accept a seller’s offer at a certain
price

Auction-Based Pricing (cont’d)
• Seller auction-based price illustrated

– Corporations such as Intel or Sun
Microsystems have excess silicon wafers
from computer chip production
– Company posts message on Internet
asking for quantity and price prospective
buyers are willing to pay for the wafers
– Demand curve of all offers is prepared
– Company accepts offer or bid that best fits
the quantity of wafers it has for sale

Auction-Based Pricing (cont’d)
• Buyer auction-based price illustrated

– Individual wants to fly roundtrip to Europe
on certain dates
– Posts needs on one of hosted auction
markets on the Internet
– After receiving offers, selects the best
suited offer

Discussion
A. Is a seller auction-based price set by

the seller or does the seller accept
offers or bids from buyers?
A. The seller requests offers from potential
buyers and then accepts the best offer
A buyer auction-based price is set by the
seller and the buyer accepts the best
offer

Cost-Based Pricing Methods
• Objective 3
– Use cost-based pricing methods to develop
prices

Cost-Based Pricing Methods
• Managers can develop a price based

on the cost of producing the product or
service
– If prices do not cover costs, the company
will fail
• Two pricing methods based on cost
– Gross margin pricing
– Return on assets pricing

Cost-Based Pricing Methods (cont’d)
The Energeez Company buys parts from outside vendors and
assembles them into portable solar panels. In the previous period,
the company produced 14,750 solar panels.
Total costs and unit costs incurred were as follows

Total Costs Unit Costs
Variable production costs
Direct materials and parts $ 88,500 $ 6.00
Direct labor 66,365 4.50
Variable manufacturing overhead 44,250 3.00
Total variable production costs $199,125 $13.50
Fixed manufacturing overhead 154,875 10.50
Total production costs $354,000 $24.00
Selling, general, and administrative expenses
Selling expenses $ 73,750 $ 5.00
General expenses 36,875 2.50
Administrative expenses 22,125 1.50
Total selling, general, and administrative expenses $132,750 $ 9.00
Total costs and expenses $486,750 $33.00
No changes in unit costs are expected this period. Desired profit for
the period is $110,625. The company uses assets totaling $921,875
in producing the panels and expects a 14% return on those assets
Gross Margin Pricing
• Gross margin
– The difference between sales and the total
production costs of those sales
• Gross margin pricing
– Cost-based pricing approach
• Price is computed using a markup percentage based on
a product’s total production costs
• Markup percentage
– Designed to include all costs other than those used in the
computation of gross margin
– Composed of selling, general, and administrative expenses
and the desired profit
Emphasizes income statement information to determine a selling price

Gross Margin Pricing (cont’d)
• This method can be easily applied

– An accounting system often provides
management with production cost data
Desired Profit + Total Selling,
General, and Administrative Expenses
Markup Percentage =
Total Production Costs
Gross Margin - Based Price = Total Production Costs per Unit

+ (Markup Percentage × Total
Production Costs per Unit)

Compute markup percentage and selling price for Energeez
Company
Desired Profit + Total Selling,
Markup Percentage =
Total Production Costs
$110,625 + $132,750
= = 68.75%
$354,000
Gross Margin - Based Price = Total Production Costs per Unit

+ (Markup Percentage × Total
Production Costs per Unit)
= $24.00 + (68.75% × $24.00)
= $40.50
• Alternate method
– State the formula in terms of a company’s
desire to recover all of its costs and make
a profit
Total Production Costs + Total Selling, General
and Administrative Expenses + Desired Profit
Gross Margin - Based Price =
Total Units Produced
$88,500 + $66,375 + $44,250 + $154,875
+ $73,750 + $36,875 + $22,125 + $110,625
=
14,750
= $597,375 ÷ 14,750 = $40.50

• Gross margin-based pricing can also be

detailed on a per unit basis
Gross Margin - Based Price = Direct Materials + Direct Labor + Variable

Manufacturing Overhead + Fixed Manufacturing
Overhead + Selling, General, and Administrative
Expenses + Desired Profit per Unit
= $6.00 + $4.50 + $3.00 + $10.50 + $5.00
+ $2.50 + $1.50 + ($110,625 ÷ 14,750)
= $40.50

Return on Assets Pricing
• Based on earning a profit equal to a

specified rate of return on assets
employed in the operation
– Focuses on a desired minimum rate of
return on assets
• Also called the balance sheet approach
to pricing

Return on Assets Pricing (cont’d)
Return on Assets − Based Price = Total Costs and Expenses per Unit
+ (Desired Rate of Return × Cost
of Assets Employed per Unit)
The formula can also be expressed as follows
Return on Assets − Based Price = [(Total Production Costs + Total Selling,

÷ Units to be Produced] + [Desired Rate
of Return × (Total Cost of Assets
Employed ÷ Units to be Produced)]

Energeez Company has an asset base of $921,875. It plans to

produce 14,750 units and it would like to earn a 14 percent
return on assets
Calculate selling price per unit using return on assets pricing
Return on Assets − Based Price = $24.00 + $9.00 +

[14% × ($921,875 ÷ 14,750)]
= $41.75

Energeez Company has an asset base of $921,875. It plans to

produce 14,750 units and it would like to earn a 14 percent
return on assets
Or, alternatively
Return on Assets − Based Price = [($354,000 + $132,750) ÷ 14,750]
+ [14% × ($921,875 ÷ 14,750)]
= $33.00 + $8.75
= $41.75
The desired profit that is used in A unit profit factor of $8.75 is obtained by
gross margin pricing is replaced dividing cost of assets employed by
by an overall company rate of projected units of output and multiplying the
return on assets result by the desired minimum rate of return

Summary of Cost-Based Pricing Methods
• Companies select their pricing methods

based on their degree of trust in a cost
base
• For Energeez Company, a higher
selling price is calculated using the
return on assets pricing method

Cost-Based
Pricing
Methods:
Energeez
Company
25–52
Summary of Cost-Based Pricing Methods
(cont’d)
• Can choose between two cost bases

– Total product costs per unit
• Data readily available
– Makes gross margin pricing a good way to compute
selling prices
– Depends upon an accurate forecast of units
– Fixed cost per unit portion of total production costs
will vary if actual and estimated number of units differ
– Total costs and expenses per unit
• Good pricing method of assets used to manufacture
a product can be identified and their cost
determined
– If not, the method yields inaccurate results

Pricing Services
• Most service organizations use a form

of time and materials pricing
– Also known as parts and labor pricing

Pricing Services (cont’d)
• Service companies such as appliance repair

shops, home-remodeling specialists, pool
cleaners, and automobile repair businesses
– Use two computations
• Direct labor
• Materials and parts
– Markup percentages are added to the costs of
materials and labor
• Covers cost of overhead and provides a profit factor

• Professionals, such as attorneys,

accountants, and consultants
– Use one computation
• Direct labor
– A markup percentage is added to the cost
of labor
• Covers cost of overhead and provides a profit
factor

Gil Marquiz completed work on Lucinda Lowe’s Mercedes.

Parts for repairs cost $840. The company's 40 percent
markup rate on parts covers parts-related overhead costs and
profit. The repairs required four hours of labor by a Mercedes
specialist, whose wages are $35 per hour. The company's
overhead markup rate on labor is 80 percent
Compute Lucinda Lowe’s bill
Repair parts used $840

Overhead charges ($840 x 40%) 336
Total parts charges $1,176
Labor charges (4 hrs @ $35 per hour) $140
Overhead charges ($140 x 80%) 112
Total labor charges 252
Total billing $1,428

Final Notes on Cost-Based Pricing Methods
• Cost-based pricing is widely used in some

areas of the economy, such as government
contracts
• Once a cost-based price has been
determined, the decision maker must
consider
– Competitor’s prices
– Customers’ expectations
– The cost of substitute products and services
Care must be taken when establishing prices—pricing
is a risky part of operating a business
Discussion
A. What are two pricing methods based

on cost?
B. Gross margin pricing

• Price is computed using a markup percentage
based on a product’s total production costs
Return on assets pricing
• Price is computed to earn a specific rate of
return on assets used in the operation

Pricing Based on Target Costing
• Objective 4
– Describe target costing and use that
concept to analyze pricing decisions and
evaluate a new product opportunity

Pricing Based on Target Costing
• Target costing
– A pricing method that
1. Identifies the price at which a product will be
competitive in the marketplace
2. Defines the desired profit to be made on the
product
3. Computes the target cost for the product
• Desired profit is subtracted from the competitive
market price
Target Price − Desired Profit = Target Cost

Pricing Based on Target Costing (cont’d)
• The target cost is given to the

engineers and product designers
– Use it as a maximum cost to be incurred
for materials and resources needed to
design and manufacture the product
– Must create the product at or below its
target cost

• Target costing is strategically superior

– Gives managers the ability to control or
dictate costs of a new product beginning
at the planning stage of the product’s life
cycle
– Enables managers to analyze a product's
potential before committing resources to
its production

Price Decision Timing Comparison

• Traditional cost-based pricing

– Prices cannot be set until production has taken
place and costs have been incurred and analyzed
• At that point, a profit factor is added to the product's cost
• Target costing
– The pricing decision takes place immediately after
the market research for a new product
• Reveals potential demand for product
• Identifies the maximum price a customer will be willing to
pay for the product
– Once the price is determined, engineers design the product
within a fixed maximum target cost

• Cost First Company

– Strategy is to jump into the planning phase, design
the product, and get it into production ASAP
– Prototype model tested during the production
phase
– Assumed that flaws will be found, change orders
will be necessary, and the production process will
have to be redesigned to fit the changes
– Total unit cost and price determined after product
has been successfully produced

• Once the company decides to produce the

new product, new costs are incurred at each
stage in the product’s life cycle
– Committed costs
• Costs of design, development, engineering, testing, and
production that are engineered into a product or service
at the design stage of development
• Should occur if all design specifications are followed
during production
– Incurred costs
• The actual costs to make the product

Traditional Cost-Based Approach to Pricing:
Committed Versus Incurred Costs
To earn a profit of 20 percent of target cost, Cost First Company

will need to price the product at about $84 [$70 cost + ($70 x .20)]
• When using cost-based pricing

– Very difficult to control costs from the planning
phase through the production phase
– Difficult for management to set realistic targets
• Because product is being made for the first time
– Focus is in sales, not on the design and
manufacture of the product
– Cost control efforts will focus on incurred costs
after the product has been introduced to the
marketplace

• Price First Company

– Market research indicated that the product would
be successful if priced at or below $48
– Target cost is determined
$48 − 20% of Target Cost = Target Cost
$48 − .2X = X
1.2X = $48
X = $40
– Engineers work on designing a product that will

comply with the cost restriction
– Production efforts are not started until the
prototype model meets the requirements for both
cost and quality
Target Costing Approach to Pricing:
Committed Versus Incurred Costs
Because a $40 maximum cost was engineered into the design of

the product, committed costs are set at that amount (much lower
than the $70 committed costs for Cost First Company)
• If engineers determine product cannot be

made at or below target cost
– Company should examine product’s design
• Try to improve the approach to production
• If product still cannot be made at its target
cost
– Company must understand that its current
facilities prevent it from competing in that
particular market
• Should either
– Invest in new equipment or procedures
– Abandon its plans to make and market the product

• Benefits of target costing

– Ability to design and build a product to a
specific cost goal
• A new product is designed only if its projected
costs are equal to or less than its target cost
Under the cost-based approach, concern about reducing
costs begins only after the product has been produced
– Product is expected to produce a profit as

soon as it is marketed
• Profitability is built into the selling price from the
beginning
Illustrative Problem: Target Costing
A customer of Zephyr Company is seeking price quotations for two
WiFi components: a special purpose router and a wireless palm-
sized computer. Current market prices for the router and computer
are $320-$380 and $750-$850 per unit, respectively. A salesperson
feels that if Zephyr could quote prices of $300 for the router and $725
for the computer, the company would get the order and gain a
significant share of the global market for those goods. Zephyr’s
usual profit markup is 25 percent of total unit cost
• Required
1. Compute the target cost for each product
2. Compute the projected total unit cost of production and
delivery
3. Use the target costing approach to determine if the
company should produce the products

Illustrative Problem: Target Costing (cont’d)
Company design engineers and accountants put together the

following specifications and costs
Activity-based cost rates
Materials handling $ 1.30 per dollar of direct materials and
purchased parts cost
Production $ 3.50 per machine hour
Product delivery $24.00 per router
$30.00 per computer
Router Computer
Projected unit demand 26,000 18,000
Per unit data: Note that
Direct materials cost $25.00 $65.00
activity-based
Purchased parts cost $15.00 $45.00
Manufacturing labor management
Hours 2.6 4.8 can be used
Hourly labor rate $12.00 $15.00 with target
Assembly labor
Hours 3.4 8.2
costing
Hourly labor rate $14.00 $16.00
Machine hours 12.8 28.4

1. Compute the target cost for each product
Router = $300.00 ÷ 1.25 = $240.00 *

Computer = $725.00 ÷ 1.25 = $580.00
* Target Price − Desired Profit = Target Cost

$300.00 − .25 X = X
$300.00
X= = $240.00
1.25

2. Compute the projected total unit cost of production and

delivery
Router Computer
Direct materials cost $ 25.00 $ 65.00
Purchased parts cost 15.00 45.00
Total cost of direct materials and parts $ 40.00 $110.00
Manufacturing labor
Router (2.6 hours x $12.00) 31.20
Computer (4.8 hours x $15.00) 72.00
Assembly labor
Router (3.4 hours x $14.00) 47.60
Computer (8.2 hours x $16.00) 131.20
Activity-based costs
Materials handling
Router ($40.00 x $1.30) 52.00
Computer ($110.00 x $1.30) 143.00
Production
Router (12.8 machine hours x $3.50) 44.80
Computer (28.4 machine hours x $3.50) 99.40
Product delivery
Router 24.00
Computer 30.00
Projected total cost $239.60 $585.60

3. Use the target costing approach to determine if the

company should produce the products
Router Computer
Target unit cost $240.00 $580.00
Less projected unit cost 239.60 585.60
Difference $ .40 ($ 5.60)
The router can be As currently designed, the computer cannot

produced below its be produced at or below its target cost so
target cost, so it the company should either redesign it or
should be produced discontinue plans to produce it

Discussion
A. How is a target cost per unit

computed?
A. First, a target price per unit must be

determined. Then, the target cost per
unit is calculated by subtracting the
desired profit from the target price
Target Price − Desired Profit = Target Cost

Pricing for Internal Providers of Goods and
Services
• Objective 5
– Describe how transfer pricing is used for
transferring goods and services and
evaluating performance within a division or
segment

Pricing for Internal Providers of Goods and
Services
• Decentralized organization
– A large business organized into divisions
or operating segments
– A separate manager controls the
operations of each segment
– Each division or segment sells its goods or
services both inside and outside the
organization
We will now focus inside an organization and how it prices its products
and services for internal transfers between divisions or segments

Transfer Pricing
• Transfer price
– Price at which goods and services are
charged and exchanged between a
company’s divisions or segments

Transfer Pricing (cont’d)
• Is an internal pricing mechanism

– Allows transactions between divisions or
segments of a business to be measured and
accounted for
– Affects the revenues and costs of the divisions
involved
• Does not affect the revenues and costs of the company
as a whole
• Shifts part of the profits from divisions that externally
charge for their goods and services to the divisions that
do not bill externally for their services and products
Transfer pricing enables a business to assess both the
internal and external profitability of its products or services
Transfer Pricing (cont’d)
• Three basic kinds of transfer prices

– Cost-plus transfer prices
– Market transfer prices
– Negotiated transfer prices

Cost-Plus Transfer Price
• Based on either the full cost or variable

costs incurred by the producing division
plus an agreed-upon profit percentage
– Weakness
• Cost recovery is guaranteed to the selling
division
– Fails to detect inefficient operating conditions and
the incurrence of excessive costs
– May inappropriately reward inefficient divisions that
incur excessive costs
– This reduces overall company profitability and
shareholder value

Market Transfer Price
• Based on the price that could be

charged if a segment could buy from or
sell to an external party
• Some experts believe this method is
preferable to other transfer pricing
methods

Market Transfer Price (cont’d)
• Advantages
– Forces selling division to be competitive
with market conditions
– Does not penalize buying division by
charging a price greater than it would have
to pay on the market

Market Transfer Price (cont’d)
• Disadvantages
– May lead selling division to ignore
negotiation attempts from buying division
and sell directly to outside customers
• Could cause an internal shortage of materials
• Forces buying division to purchase materials
from the outside
• Overall company profits may fall even though
selling division makes a profit
When market prices are used to develop transfer prices,
they are usually used only as a basis for negotiation
Negotiated Transfer Price
• Is arrived at through bargaining between the

managers of the buying and selling divisions
or segments
– May be based on an agreement to use a cost plus
a profit percentage
– Will be between the negotiation floor and the
negotiation ceiling
• Negotiation floor This approach allows
for cost recovery
– The selling division’s variable cost while still allowing the
• Negotiation ceiling selling division to
– The market price return a profit

Developing a Transfer Price
Simple Box Company has two divisions: the Pulp Division and the
Cardboard Division. The Pulp Division produces pulp for the
Cardboard Division. The Cardboard Division may also purchase
pulp from outside suppliers

Transfer Price Computation

Developing a Transfer Price (cont’d)
• Developing a cost-plus transfer price for the

Pulp Division
– Manager has developed a one-year budget based
on the expectation that the Cardboard Division will
require 480,000 pounds of pulp
– Allocated corporate overhead is not included in
computation of the transfer price
• Only variable costs and fixed costs related to the Pulp
Division are included
– The final cost-plus transfer price is $14.19 per
pound

• Two possible outcomes

– Management can dictate that the $14.19
price be used
– The manager of the Cardboard Division
can point out that an outside supplier is
selling pulp for $13.00 per pound
• Use of the $13.00 price represents a market
value approach

• The situation can be resolved by negotiating

a transfer price between the floor and ceiling
– Floor is equal to variable costs of $11.85
– Ceiling is equal to the market price of $13.00
• The negotiation process will facilitate each
manager’s role in maximizing company-wide
profits and controlling his or her division’s
costs

• Both managers brought their concerns

to the attention of top management
– Company did not want the Cardboard
Division to buy pulp from an outside source
– The Pulp Division should have an incentive
to move toward the market price

• Negotiated price allows for the sharing

between divisions of the final product’s
company-wide profits when the boxes are
sold on the outside market
• Approach is used to maintain harmony within
an organization
• Allows top management to measure Pulp
Division managers’ performance against a
competitive price for pulp
• The price of the final product takes into
account all operations of the business

• Cardboard Division
– Should purchase pulp from outside source if the
overall annual cost is less than the Pulp Division’s
incremental costs
• Pulp Division
– Since it has adequate capacity to fulfill Cardboard
Division’s demands, it should sell to the Cardboard
Division at any price that recovers incremental
costs
• Incremental costs include all variable costs of production
and distribution plus any avoidable fixed costs directly
traceable to intracompany sales
• If the market price of pulp is below the

Pulp Division’s incremental cost, and
expected to remain so for an extended
period of time
– The Cardboard Division should buy from
an outside supplier
– The Pulp Division should theoretically
cease operations, at least temporarily
– A thorough analysis of the Pulp Division’s
operations should be conducted

Using Transfer Prices to Measure
Performance
• Transfer prices
– Contain an estimated amount of profit
• Therefore, a manager’s ability to meet a targeted profit
can be measured
– Are often called artificial or created prices
• When transfer prices are used
– A division can be evaluated as a profit center
• Using transfer prices to value a division’s output
simulates revenues for the division
• Operating income calculated in this way is not based on
real sales to outsiders, but is a valuable performance
measure if transfer prices are realistic

Performance
Report Using
Transfer
Prices
25–100
Using Transfer Prices to Measure
Performance (cont’d)
• Pulp Division’s actual gross margin was ($1,725),

whereas budgeted gross margin was $4,200
– Difference of $5,925
• Stems from cost overages in various materials, labor, and
variable overhead accounts
• Differences will need to be investigated
• Use of transfer prices to simulate income allows
further evaluation
– Return on investment
• Measures of operating income (loss) can be compared with
amount of capital invested in the Pulp Division
– Impact of uncontrollable costs from corporate office can be
assessed

Transfer Pricing in Retail and Service
Companies
Auto Imports is an automobile dealership that sells and leases
new and used cars and provides service through its
Maintenance and Body Shop departments. There is a need for
transfer prices in at least seven points of contact among its
five departments. Because market prices are readily available,
the company uses market prices for transfer pricing

Discussion
A. What is a transfer price?
A. A transfer price is an internal pricing

mechanism that allows transactions
between divisions or segments of a
business to be measured and accounted
for

Time for Review
1. Identify the objectives and rules used

to establish prices of goods and
services, and relate pricing issues to
the management cycle
2. Describe economic pricing concepts
including the auction-based pricing
method used on the Internet
3. Use cost-based pricing methods to
develop prices

And Finally…
1. Describe target costing and use that

concept to analyze pricing decisions
and evaluate a new product
opportunity
2. Describe how transfer pricing is used
for transferring goods and services
and evaluating performance within a
division or segment

Transfer Pricing3

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Chapter 25

1. Identify the objectives and rules used

Copyright © Houghton Mifflin Company. All rights reserved. 25–2

1. Describe target costing and use that

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• There are many approaches to setting

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• Factors to consider when analyzing the

Managers perfect the art of price setting through experience in

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• Setting appropriate prices

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• Companies use pricing policies to

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• Possible objectives of a pricing policy include

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• Underlying objective of pricing policies

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• Socially responsible pricing

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• Maintain a minimum rate of return on

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• Important, when setting prices to

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• To stay in business, an organization’s

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• Any deviation must be for a specific

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• When making and evaluating pricing

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A. What are the four rules for setting a

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• Economic approach to pricing

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• It may seem that if a company could

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• Total revenue curve

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• Total cost curve

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• Marginal revenue and marginal cost are used

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• Graphic curves for marginal revenue

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• Information used in microeconomic

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• Occurs two ways

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• Seller auction-based price illustrated

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• Buyer auction-based price illustrated

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