Financial Control
Chapter 11 – Transfer Pricing
© 2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing

Transfer pricing is the set of rules an organization
uses to allocate jointly earned revenue among
responsibility centers

To understand the issues and problems associated
with allocating revenues in a simple organization,
consider the activities that occur when a customer
purchases a new car at a dealership:
© 2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing
– The new car department sells the new car and takes
in a used car as a trade
– The used car is transferred to the used car
department
– There, it may undergo repairs and service to make
it ready for sale, or may be sold externally on the
wholesale market

The value placed on the used car transferred
between the new and used car departments is
critical in determining the profits of both
departments:
© 2012 Pearson Prentice Hall. All rights reserved.
Transfer Pricing
– The new car department would like the value
assigned to the used car to be as high as possible to
increase revenue
– The used car department would like the value to be
as low as possible because that makes its reported
costs lower

The same considerations apply for any product or
service transfer between any two departments in
the same organization
© 2012 Pearson Prentice Hall. All rights reserved.
Approaches to
Transfer Pricing

Organizations choose among four main
approaches to transfer pricing:
– Market-based transfer prices
– Cost-based transfer prices
– Negotiated transfer prices
– Administered transfer prices
© 2012 Pearson Prentice Hall. All rights reserved.
Market-Based Transfer Price


If external markets exist for the intermediate
(transferred) product or service, then market prices
are the most appropriate basis for pricing the
transferred good or service between responsibility
centers
The market price provides an independent
valuation of the transferred product or service, and
of how much each profit center has contributed to
the total profit earned by the organization on the
transaction
© 2012 Pearson Prentice Hall. All rights reserved.
Cost-Based Transfer Price

Some common cost-based transfer prices are:
– Variable cost
– Variable cost plus a percent markup on variable
cost
– Full cost
– Full cost plus a percent markup on full cost

Economists argue that any cost-based transfer
price other than marginal cost leads organization
members to choose a lower than optimal level of
transactions
© 2012 Pearson Prentice Hall. All rights reserved.
Problems with Cost-Based
Transfer Price

The selling division will never show a profit on
any internal transfer.

Transfer prices based on actual costs provide no
incentive to the supplying division to control
costs, because the supplier can always recover its
costs
© 2012 Pearson Prentice Hall. All rights reserved.
Problems with Cost-Based
Transfer Price

Cost-based pricing does not provide the proper
economic guidance when operations are capacity
constrained
– Production decisions near full capacity should
reflect the most profitable use of the capacity, not
only cost considerations
– The transfer price should be the sum of the
marginal cost and the opportunity cost of capacity,
where opportunity cost reflects the profit of the
best alternative use of the capacity
© 2012 Pearson Prentice Hall. All rights reserved.
Negotiated Transfer Price


Some organizations allow supplying and receiving
responsibility centers to negotiate transfer prices
between themselves
Negotiated transfer prices reflect the
controllability perspective inherent in
responsibility centers, because each division is
ultimately responsible for the transfer price that it
negotiates
– Negotiated transfer prices and therefore production
decisions may reflect the relative negotiating skills
of the two parties rather than economic
considerations
© 2012 Pearson Prentice Hall. All rights reserved.
Problems with Negotiated
Transfer Price

Problems arise when negotiating transfer prices
because the bilateral bargaining situation causes:
– The supplying division to want a higher than
optimal price
– The receiving division to want a lower than optimal
price

When the actual transfer price is different from the
optimal transfer price, the organization as a whole
suffers
© 2012 Pearson Prentice Hall. All rights reserved.
Negotiated TP Rules
The selling division’s lowest acceptable transfer price is calculated as:
Transfer Price 
Variable cost
Total contribution margin on lost sales
+
per unit
Number of units transferred
Let’s calculate the lowest and highest acceptable
transfer prices under three scenarios.
The buying division’s highest acceptable transfer price is calculated as:
Transfer Price  Cost of buying from outside supplier
If an outside supplier does not exist, the highest acceptable transfer price
is calculated as:
Transfer Price  Profit to be earned per unit sold (not including the transfer price)
Administered Transfer Price

An arbitrator or a manager applies some policy to
set administered transfer prices
– Organizations often use administered transfer
prices when a particular transaction occurs
frequently

Such prices reflect neither pure economic
considerations, as do market-based or cost-based
transfer prices, nor accountability considerations,
as negotiated transfer prices do
© 2012 Pearson Prentice Hall. All rights reserved.
Transfer Prices Based
on Equity Considerations


Administered transfer prices are usually based on
cost
Sometimes administered transfer prices are based
on equity considerations:
– Relative cost method
– Base the allocation of cost on the profits that each
manager derives from using the asset
– Assign each manager an equal share of the asset’s
cost
© 2012 Pearson Prentice Hall. All rights reserved.