19
Transfer Pricing,
Evaluating and Managing
Performance
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Transfer Pricing
The amount charged when one division of an
organization sells goods or services to another
division.
Battery Division
Auto Division
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Impact of Transfer Pricing on
Organizations
If the divisions are evaluated on profitability, the
transfer price can have an impact on the
performance of each division.
Battery Division
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The higher the
transfer price to
the auto division, Auto Division
the . . .
Greater the
profits of the
battery division.
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Setting Transfer Prices
The value placed on transfer goods is used to
make it possible to transfer goods between
divisions while allowing them to retain their
autonomy.
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Goal and Behavioral Congruence
In a decentralized organization, the managers
of profit centers and investment centers often
have considerable autonomy in deciding
whether to accept or reject orders and whether
to buy from inside or outside the organization.
The goal in setting the transfer price is to provide
incentives for each division manager to act in the
company’s best interests.
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General Transfer-Pricing Rule
Transfer
Price
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=
Additional outlay
cost per unit
incurred because
goods are
transferred
+
Opportunity cost
per unit to the
organization
because of the
transfer
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Setting Transfer Prices
Let’s consider two different examples
of setting transfer prices.
1. The company has no excess capacity.
2. The company has excess capacity.
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Scenario 1: No Excess Capacity

The Battery Division of Wills Company makes a standard 12volt battery. The division is currently producing at capacity of
300,000 batteries, and sells each battery to outside companies
for $60. The company has no excess capacity. The Vehicle
Division offers to purchase 100,000 batteries for $45 each.
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Scenario 1: No Excess Capacity
Battery
Division
Transfer price = Outlay cost + Opportunity cost
$60
=
$40
+
$20
Vehicle
Division
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Scenario 1: No Excess Capacity
The offer of $45 per battery by the Vehicle Division will
not be accepted by the Battery Division.
Battery
Division
Transfer price = Outlay cost + Opportunity cost
$60
=
$40
+
$20
Vehicle
Division
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Scenario II: Excess Capacity

The Battery Division of Wills Company makes a standard 12volt battery. The division is currently producing 200,000
batteries. Full capacity for the Division is 300,000 batteries. The
Division currently sells all batteries to outside companies for
$60 each. The Vehicle Division offers to purchase 100,000
batteries for $45 each.
Transfer price = Outlay cost + Opportunity cost
$40
=
$40
+
$0
The offer of $45 per battery by the Vehicle Division
will be accepted by the Battery Division. Each battery
sold to the Vehicle Division will produce $5 in
contribution to the Battery Division.
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Difficulty in Implementing the General
Rule
1. The general rule is often difficult or impossible to
implement due to the difficulty of measuring
opportunity costs.
2. Under imperfect competition, a single producer
can affect the market price by varying the
amount of product available in the market.
3. Transfer pricing can be quite complex when
selling and buying divisions cannot sell and buy
all they want in perfectly competitive markets.
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Transfers Based on the External Market
Price
General Rule When Producing Division Has No
Excess Capacity and Perfect Competition
Prevails
Transfer price = Outlay cost + Opportunity cost
Transfer price = Market price
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Transfers Based on the External Market
Price
The Producing Division Has Excess Capacity or
the External Market is Imperfectly Competitive
1. If the transfer price is set at market price, the
producing division should have the option to
either produce goods for internal transfer or sell
in the external market.
2. The buying division should be required to
purchase goods from inside its organization if the
producing division’s goods meet the product
specifications.
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Transfers Based on the External Market
Price
Distress Market Prices
Occasionally an industry experiences a period of
significant excess capacity and extremely low prices.
Basing transfer prices
on market prices can
lead to decisions that
are not in the best
interests of the overall
company
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Producing division managers
might prefer to move the division
to a more profitable product line.
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Negotiated Transfer Prices
Division managers actually negotiate the price at
which transfers will be made.
Negotiations can lead
to divisiveness and
competition between
participating division
managers.
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Although negotiating
skill is a valuable
managerial talent, it
should not be the sole
or dominant factor in
evaluating a division
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Cost-Based Transfer Prices
When a company does not use market prices or
negotiated prices to determine transfer price, it
usually turns to cost-based transfer-pricing.
The cost-based transfer price may be based upon:
1. Unit-level cost.
2. Absorption cost.
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Using Standard Unit-Level Cost
When using this approach, the producing division is
not allowed to show any contribution margin on the
transferred products or services.
The producing division has no positive incentive to
produce and transfer products or services efficiently.
Some companies avoid these problems by
setting the transfer price at standard unitlevel cost plus a markup.
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Using Absorption Cost
Absorption cost is equal to the product’s unit-level cost
plus an assigned portion of the higher-level costs
(batch-level, product-line-level, customer-level, and
facility-level costs.
The Battery Division has
unit-level costs of $40 and
assigned higher-level costs
of $3,600,000. The Division
expects to produce
200,000 batteries during
the period.
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Dysfunctional Decision-Making


The Battery Division has excess capacity of 100,000
units and uses absorption cost to set the transfer price of
$58 per battery.
The Vehicle Division offers to purchase 100,000
batteries at a price of $55 per battery.
Will the offer be accepted?
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Dysfunctional Decision-Making
$ 55
58
$ (3)
Per unit offer from Vehicle Division
Transfer cost of Battery Division
Loss per unit
It appears the offer will be rejected.
Per unit offer from Vehicle Division
Unit-level cost to Battery Division
Contribution to company as a whole
$ 55
40
$ 15
The transfer is a benefit to the
company as a whole.
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Standard versus Actual Costs
Transfer prices should not be based on actual
costs because such a practice would allow an
inefficient producing division to pass its excess
production costs on to the buying division via the
transfer price.
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Remedying Motivational Problems
of Transfer-Pricing Policies
If profits of the selling division are too low, the
manager has no motivation to make internal
transfer.


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Consider treating the selling division as a cost
center.
Consider a profit center for external sales and
a cost center for internal transfers.
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Undermining Divisional Autonomy
Top management may become swamped with
pricing disputes causing division managers to
lose autonomy.
You really
don’t have any
choice!
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I just won’t
pay $58 for
that battery!
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Undermining Divisional Autonomy
Top management may become swamped with
pricing disputes causing division managers to
lose autonomy.
Now, here is what the two
of you are going to do.
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Dual Transfer Prices
A dual transfer-pricing system charges the
buying division for the cost of the transferred
product, however the cost might be
determined, and credits the selling division
with the cost plus some profit allowance.
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Multinational Transfer Pricing
Since tax rates are different in different countries,
companies have incentives to set transfer prices
that will increase revenues in low-tax countries
and increase costs in high-tax countries.
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Multinational Transfer Pricing
Country A imports materials from the
company’s Country B facility. The tax rate
in Country A is 70 percent and in Country B
is 40 percent
Country A
(40% tax rate)
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Country B
(70% tax rate)
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Multinational Transfer Pricing
Country A can use a transfer price of $3,000,000 or
$10,000,000. Let’s see the impact of this pricing.
$3,000,000 transfer price
Country A
$
3,000,000
(2,000,000)
Revenue
Third-party costs
Transferred goods cost
Taxable income
Income tax rate
Tax liability
$
1,000,000
40%
400,000
Country B
$
24,000,000
(6,000,000)
(3,000,000)
15,000,000
70%
$
10,500,000
Total
$
10,900,000
$10,000,000 transfer price
Country A
$ 10,000,000
(2,000,000)
Revenue
Third-party costs
Transferred goods cost
Taxable income
8,000,000
Income tax rate
40%
Tax liability
$ 3,200,000
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Country B
$ 24,000,000
(6,000,000)
(10,000,000)
8,000,000
70%
$ 5,600,000
Total
$ 8,800,000
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Segment Reporting
Companies engaged in different lines of
business are required to report certain
information about segments.
o
o
o
o
o
o
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Revenue.
Operating profits or losses.
Identifiable segment assets.
Depreciation and amortization.
Capital expenditures.
Certain specialized items.
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Segment Reporting
If a company has significant foreign
operations, it must disclose . . .
o Revenues.
o Operating profits or losses.
o Identifiable assets by geographic region.
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Transfer Pricing in the Service Industry
Service industry firms and nonprofit
organizations use transfer pricing when
services are transferred between
responsibility centers.
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End of Chapter 19
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