Transfer Pricing
Key Concepts/Definitions
A 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.
Transfer Pricing
The amount charged when one division sells
goods or services to another division
Batteries
Battery Division
Auto Division
Three Primary Approaches
There are three primary
approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.
Negotiated Transfer Prices
A negotiated transfer price results from discussions
between the selling and buying divisions.
Range of Acceptable
Transfer Prices
Upper limit is
determined by the
buying division.
Lower limit is
determined by the
selling division.
Barker Company – An Example
Assume the information as shown with
respect to The Battery Division and Vehicle
Division (both Division’s are owned by Barker
Company).
Battery Division:
Production Capacity (Number of Batteries)
300,000
Variable cost per battery
£18
Fixed costs per month
£2,100,000
Selling price per battery to outsiders
£40
Vehicle Division:
Purchase price per battery from outside supplier
£39
Monthly comsumption of batteries
50,000
Barker Company –Scenario 1
Suppose that the Battery Division is operating at
capacity.
What is the lowest acceptable transfer price from the
viewpoint of the Battery Division?
What is the highest acceptable transfer price from
the viewpoint of the Vehicle Division?
Will a transfer take place?
General Guideline for Determining
a Minimum Transfer Price
Minimum transfer price
= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division
Barker Company – Scenario 1
As indicated, the Battery Division is operating at capacity. The Battery
Division’s acceptable transfer price is calculated as:
Transfer Price 
Variable cost
Total contribution margin on lost sales
+
per unit
Number of units transferred
The Vehicle Division’s acceptable transfer price is calculated as:
Transfer Price
 Cost of buying from outside supplier
Barker Company – Scenario 1
If Battery Division has no idle capacity (0 batteries) and must sacrifice other
customer orders (50,000 batteries) to meet Vehicle Division’s demands
(50,000 barrels), then the lowest and highest possible transfer prices are
computed as follows:
Selling division’s lowest possible transfer price:
Transfer Price  £18 +
( £40 - £18) × 50,000
= £40
50,000
Buying division’s highest possible transfer price:
Transfer Price  Cost of buying from outside supplier
Therefore, there is no range of acceptable
transfer prices.
= £39
Barker Company – Scenario 2
Refer to the original data. Assume that the
Battery Division has enough idle capacity to supply the
Vehicle Division’s needs without diverting batteries
from the outside market.
What is the lowest acceptable transfer price from
the viewpoint of the Battery Division? In what price
range will a transfer take place?
Barker Company – Scenario 3
Refer to the original data. Suppose the Battery Division is
selling 275,000 batteries per month on the outside market. The
Vehicle Division can put only one kind of batteries in its vehicles.
It cannot buy 25,000 batteries from an outside supplier and
25,000 batteries from the Battery Division: it must buy all of its
batteries from one source. The Battery Division must sacrifice
some outside customer orders to meet the Vehicle Division’s
demands.
What is the lowest acceptable transfer price from the
viewpoint of the Battery Division? In what price range will a
transfer take place? Is this transfer “goal-congruent” for the
Company (Barker)?
An Example
Materials used by the Truck Division of Structure Motors are currently
purchased from outside suppliers at a cost of $260 per unit. However, the
same materials are available from the Component Division. The
Component Division has unused capacity and can produce the materials
needed by the Truck Division at a variable cost of $190 per unit.
a.
If a transfer price of $230 per unit is established and 40,000 units of
material are transferred with no reduction in the Component Division’s
current sales, how much would Structure Motors’ total income from
operations increase?
b. How much would the Truck Division’s income from operations increase?
c.
How much would the Component Division’s income from operations
increase?
d. Let’s change the transfer price to $250. Recalculate a, b and c above.
What additional insights can we gain?
Evaluation of Negotiated Transfer
Prices
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.
Cost-Based Transfer Prices
Some companies use the following measures of cost to
establish transfer prices . . .
Variable cost (₤18 for the Battery Division). The selling
division will never show a profit on any internal
transfer.
Full absorption cost (₤25 for the Battery Division)
Will the Battery Division transfer at Full Cost if it has no
capacity?
What happens if the Battery Division has capacity and
the Auto Division can sell batteries at ₤23 in a
foreign country?
Mark-up (e.g. 120% of full cost, or ₤30 per battery).
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.
Note:
•
1. 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. In the Battery
Division example, the price would be set at ₤40.
•
2. A market price approach does not work well when the
selling division has idle capacity. What happens if the
Battery Division has excess capacity? Will it prefer to sell at
a price below ₤40?
An International Perspective
Since tax rates are different in different countries, companies
have incentives to set transfer prices that will:
• Increase revenues in low-tax countries.
• Increase costs in high-tax countries.