TRANSFER PRICING 1

• Transfer Pricing


  The amount charged by one segment for goods or services transferred to another segment
• Objectives of Transfer Pricing

  • To facilitate optimal decision-making
  • To provide a basis in measuring divisional performance
  • To motivate the different department heads in improving their performance and that of their departments
• Factors in Determining Transfer Price

  • Goal Congruence - Does the transfer price beneficial for the company as a whole?
  • Segment Performance - What is the benefit or loss for individual segment?
  • Capacity - Does the selling segment is operating at full capacity?
  • Cost Structure - What cost are variable and fixed?
• Methods in Determining Transfer Price

  • Cost-based transfer price
  • Market-based transfer price
  • Negotiated transfer price
• Maximum Transfer Price


  Determined by the buying DIVISION and should be NO GREATER than the lowest market price at which the buying segment can acquire the goods externally
• Minimum Transfer Price


  Determined by the selling DIVISION and should be NO LESS than the sum of the selling segments incremental costs associated with the goods or services plus any opportunity costs of the facility used
• Transfer Pricing: Transfer Price is the price charged by one division to another
• Objective of Transfer Pricing

  To set transfer price to achieve goal congruence
• End Goal of Transfer Pricing

  To maximize the NI of the whole company
• ABC Company: SP 100, VC 40, CM 60, Capacity: Selling 10,000 units, Buying 2,000 units, P 120/units
• When a company segment is operating at full capacity

  The lost CM per unit on outside sales is the opportunity cost of transferring products to another company segment
• Other Types of Transfer Pricing

  • Cost plus (cost + markup)
  • Variable Cost (DM, DL, VOH, VS&A)
  • Full production cost (DM, DL, OH)
  • Negotiated Price
  • Market-based Price
• Cost plus (cost + markup)


  • May be based on full cost, variable cost, or some modification including a markup
  • Often leads to poor performance evaluations and purchasing decisions
  • Under this approach, divisions sometimes use improper transfer prices which leads to a loss of profitability and unfair evaluations of division performance
  • Does not provide the selling division with proper incentive
  • Does not reflect the selling division's true profitability and doesn't even provide adequate incentive for the selling division to control costs since the division's costs are passed on to the buying division
• Variable Cost (DM, DL, VOH, VS&A)


  • Uses all of the variable costs, including selling and administrative costs, as the cost base and provides for fixed costs and target ROI through the markup
  • Is more useful for making short-run decisions because it considers variable cost and fixed cost behavior patterns separately
  • More consistent with cost-volume-profit analysis used to measure the profit implications of changes in price and volume
  • Provides the type of data managers need for pricing special orders
  • Avoids arbitrary allocation of common fixed costs to individual product lines
• Full production cost (DM, DL, OH)

  • Uses total manufacturing cost as the cost base and provides for selling/administrative costs plus the target ROI through the markup
• Negotiated Price


  • Selling division, establishes, a minimum transfer price and the purchasing division establishes a maximum transfer price
  • Companies often do not use negotiated transfer pricing because: Market price information is sometimes not easily obtainable, A lack of trust between the two negotiating divisions may lead to a breakdown in negotiations, Negotiations often lead to different pricing strategies from division to division which is sometimes costly to implement
• Market-based Price


  • Based on existing market prices of competing goods
  • Often considered the best approach because it is objective and generally provides the proper economic incentives