transfer pricing

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Transfer Pricing

DefinitionsA transfer price is the price

charged when one segment of a company provides goods or

services to another segment of the company.

The fundamental objective in setting transfer prices is to

motivate managers to act in the best interests of the overall

company.

1. To provide information that motivates divisional managers to make good economic decisions.

2. To provide information that is useful for evaluating the managerial and economic performance of the divisions.

3. To intentionally move profits between divisions or locations.

4. To ensure that divisional autonomy is not undermined.

Purposes of transfer pricing

Information for making good decisions

• Intermediate products = Goods transferred from the supplying to receiving division.• Final products = Products sold by the receiving division to the outside world

• Example Incremental cost of making intermediate product = £100 Incremental further processing costs in receiving division = £60 Market price of final product = £200 No external market for the intermediate product and spare capacity Cost-plus 50% transfer price = £150 Business will be rejected if TP set at £150


• Evaluating managerial performance

• TP of £60 incremental cost of supplying division would motivate correct decision but it does not form a basis for measuring the performance of the supplying division.

• A conflict of objectives exists which can be difficult to resolve.


1. Market-based2. Variable Cost3. Full cost4. Cost-plus a mark-up5. Negotiated transfer prices

Transfer Pricing Methods

Transfers at Market Price

A market price (i.e., the price charged for an item on the open market) is often regarded as the best

approach to the transfer pricing problem.

1. Where there is a perfectly competitive market for the intermediate product, the current market price is the most suitable basis for setting the transfer prices.

2. TP ’s will motivate sound decisions and form a suitable basis for performance evaluation

3. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity.

4. A market price approach does not work well when the selling division has idle capacity.

Transfers at the Cost to the Selling Division

Many companies set transfer prices at either the variable cost or full (absorption) cost

incurred by the selling division.Drawbacks of this approach include:

1. Using full cost as a transfer price and can lead to suboptimization.

2. The selling division will never show a profit on any internal transfer.

3. Cost-based transfer prices do not provide incentives to control costs.

Oslo = Supplying division (No external market for the intermediate product)Bergen = Receiving division (converts intermediate to final product)Expected sales of the final product:

Net selling price Quantity sold(£) Units100 1 000 90 2 000 80 3 000 70 4 000 60 5 000 50 6 000

The costs of each division are:Oslo Bergen

Variable cost per unit £ 11 £ 7Fixed costs 60 000 90 000The transfer price of the intermediate product has been set at £35 based on a full cost plus mark-up.

Suboptimization Example

• £35 TP does not motivate optimum output level for the company as a whole.

• To ensure overall company optimality the TP must be set at VC of the intermediate product (i.e VC of £11 per unit or £11,000 per batch of 1,000 units).


Negotiated transfer prices• Most appropriate where there are market imperfections for the

intermediate product and managers have equal bargaining power.• To be effective managers must understand how to use cost and revenue

information.• Claimed behavioural advantages.• Limitations:1. Can lead to sub-optimal decisions2. Time - consuming3. Divisional profitability may be strongly influenced by the bargaining

skills and powers of the divisional managers.4. Inappropriate in certain circumstances (e.g. no market for the

intermediate product or an imperfect market exists).

Transfer Pricing Methods

Negotiated Transfer Prices

A negotiated transfer price results from discussions between the selling and buying divisions.

Advantages of negotiated transfer prices:

1. They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization.

2. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

Upper limit is determined by

the buying division.

Lower limit is determined by

the selling division.

Range of Acceptable Transfer Prices

Harris and Louder – An Example

Imperial Beverages:Ginger beer production capactiy per month 10,000 barrelsVariable cost per barrel of ginger beer £8 per barrelFixed costs per month £70,000Selling price of Imperial Beverages ginger beer on the outside market £20 per barrel

Pizza Maven:Purchase price of regular brand of ginger beer £18 per barrelMonthly comsumption of ginger beer 2,000 barrels

Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder).


The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as:

Variable cost Total contribution margin on lost salesper unit Number of units transferredTransfer Price +

Transfer Price Cost of buying from outside supplier

The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as:

Transfer Price Profit to be earned per unit sold (not including the transfer price)

If an outside supplier does not exist, the highest acceptable transfer price is calculated as:


If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza Maven’s demands (2,000 barrels) without sacrificing sales to other

customers, then the lowest and highest possible transfer prices are computed as follows:

£02,000 = £8Transfer Price +£8

Selling division’s lowest possible transfer price:

Transfer Price Cost of buying from outside supplier = £18Buying division’s highest possible transfer price:

Therefore, the range of acceptable transfer price is £8 – £18.


If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice other customer orders (2,000 barrels) to meet Pizza Maven’s demands (2,000

barrels), then the lowest and highest possible transfer prices are computed as follows:

( £20 - £8) × 2,0002,000 = £20Transfer Price +£8

Selling division’s lowest possible transfer price:


Therefore, there is no range of acceptable transfer prices.


If Imperial Beverages has some idle capacity (1,000 barrels) and must sacrifice other customer orders (1,000 barrels) to meet Pizza Maven’s

demands (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows:


Therefore, the range of acceptable transfer price is £14 – £18.

Selling division’s lowest possible transfer price:( £20 - £8) × 1,000

2,000 = £14Transfer Price +£8

Evaluation of Negotiated TP

If a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within

which both the selling and buying divisions would have higher profits if they agree to the transfer.

If managers are pitted against each other rather than against their past performance or reasonable benchmarks, a noncooperative

atmosphere is almost guaranteed.

Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices.

Dual rate TP system• Uses two transfer prices1. Supplying division may receive full cost plus a mark-up so that it

makes a profit on inter-divisional transfers (e.g Oslo TP > £23).2. Receiving division charged at VC of transfers thus motivating

managers to operate at the optimum output level for the company as a whole.

3. Profit on inter-group trading removed by an accounting adjustment.• Not widely used because:1. Use of two TP ’s causes confusion2. Seen as artificial3. Divisions protected from competition4. Reported inter-divisional profits can be misleading

Resolving transfer pricing conflicts

Variable cost plus a lump sum fee

• Intended to motivate receiving division to equate VC of transfers with its net marginal revenue to determine optimum company profit maximizing output level.

• Enables supplying division to cover its fixed costs and earn a profit on inter-divisional transfers through the fixed fee charged for the period.

• Motivates receiving division to consider full cost of providing intermediate products/services (.TP = £11 MC plus £60,000 lump sum plus a profit contribution in the example).

Resolving transfer pricing conflicts

• Competitive market for the intermediate product — Use market prices.

• No market for the intermediate product or an imperfect market — Transfer at MC plus a lump sum or negotiation may be appropriate in certain circumstances.

• Use standard costs for cost-based TP ’s

Domestic TP conclusions

• Where divisions are located in different countries taxation implications become important and TP has the potential to ensure that most of the profits on inter-divisional transfers are allocated to the low taxation country.

International transfer pricing

Division-B has asked Division-A of the same company to supply it with 6,000 units of a part this year to use in one of its products. Division-B has received a bid from an outside supplier for the parts at a price of Rs.17 per unit. Division-A has the capacity to produce 30,000 units of this part per year. Division-A expects to sell 27,000 units of the part to outside customers this year at a price of Rs.18 per unit. To fill the order from Division-B, Division-A would have to cut back its sales to outside customers.Division-A produces part at a variable cost of Rs.9 per unit. The cost of packing and shipping the parts for outside customers is Rs.1 per unit. These packing and shipping costs would not be incurred on sales of the parts to Division-B.Required:Calculate the range of transfer prices within which both the Divisions' profits would increase as a result of agreeing to transfer 6,000 parts this year from Division-A to Division-B.

Practice Question

SolutionFrom the perspective of Division B, profits would increase as a result of the transfer if and only if: Transfer price ≥ Variable cost + Opportunity costThe opportunity cost is the contribution margin on the lost sales, divided by the number of units transferred:Opportunity cost = [(Rs.18.00 - Rs.9.00 - Rs.1.00) × 3,000*]/6,000 = Rs.4.00* Demand from outside customers 27,000 Units required by Division B 6,000 Total requirements 33,000 Capacity 30,000 Required reduction in sales to outside customers 3,000 Therefore, Transfer price ≥ Rs.9.00 + Rs.4.00 = Rs.13.00. 1From the viewpoint of Division A, the transfer price must be less than the cost of buying the units from the outside supplier. Therefore, Transfer price ≤ Rs.17.00.Combining the two requirements, we get the following range of transfer prices:Rs.13.00 ≥ Transfer price ≤ Rs.17.00.

An organization has two divisions, X-Division and Y-Division. X-Division produces two products A and B. Product A is sold to external customers for Rs. 210 per unit. The only outlet for product B is Y-Division. Y-Division supplies to an external market and can obtain its semi-finished supplies (product B) from either X-Division or from an external source. Division-Y currently has the opportunity to purchase product B from an external supplier for Rs. 190 per unit. The capacity of X-Division is measured in unit of output, irrespective of whether product A, B or combination of both are being produced. The associated product costs are as follows:

Rupees Product A BVariable costs per unit 160 175 Fixed overheads per unit 25 25 Total costs per unit 185 200 Required:Transfer price for the sale of Product B from X-Division under the following options:(i) X-Division has spare capacity and limited external demand for product A(ii) X-Division is operating at full capacity with unsatisfied external demands for product A

Practice Question

Solution•X-Division is Operating at Full Capacity with unsatisfied demand of A•If X-Div chooses to Supply to Y-Div then its Opportunity Cost is•Opportunity Cost = 210 -160 = 50•In this situation relevant cost of Supply = 175 +50 = 225

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