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I. Appendix 11A: transfer pricing (Slide #1 is a title slide)
A. Key concepts/definitions
i. A transfer price is the price charged when one
segment of a company provides goods or
services to another segment of the company.
While domestic transfer prices have no direct
effect on the entire company’s reported profit,
they can have a dramatic effect on the reported
profitability of a division.
ii. The fundamental objective in setting transfer
prices is to motivate managers to act in the best
interests of the overall company.
Suboptimization occurs when managers do
not act in the best interests of the overall
company or even their own divisions.
Helpful Hint: Emphasize that a good transfer price is
one that induces division managers to do whatever is in
the best interest of the entire company. Students often
take for granted that divisions should make all
purchases internally whenever possible – which of
course is not the case. They also sometimes lose sight of
the purpose of transfer pricing in their zeal to be “fair”
to the various divisions.
iii. There are three primary approaches to
setting transfer prices, namely negotiated
transfer prices, transfers at the cost to the
selling division, and transfers at market price.
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B. Negotiated transfer prices
Learning Objective 5: Determine the range, if any,
within which a negotiated transfer price should fall.
i. A negotiated transfer price results from
discussions between the selling and buying
divisions.
1. Negotiated transfer prices have two
advantages:
a. They preserve the autonomy of the
divisions, which is consistent with the
spirit of decentralization.
b. 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.
2. The range of acceptable transfer prices is
the range of transfer prices within which the
profits of both divisions participating in the
transfer would increase.
a. The lower limit is determined by the
selling division.
b. The upper limit is determined by the
buying division.
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ii. Grocery Storehouse– an example
1. Assume the information as shown with
respect to West Coast Plantations (WCP)
and Grocery Mart (both companies are
owned by Grocery Storehouse).
a. The selling division’s (WCP) lowest
acceptable transfer price is
calculated as shown.
b. The buying division’s (Grocery Mart)
highest acceptable transfer price is
calculated as shown.
(1). If Grocery Mart had no outside
supplier for oranges, then its
highest acceptable transfer price
would be equal to the amount it
expects to earn by selling the
oranges, net of its own expenses.
c. Let’s calculate the lowest and highest
acceptable transfer prices under three
scenarios.
2. If WCP has sufficient idle capacity (3,000
crates) to satisfy Grocery Mart’s demands
(1,000 crates) without sacrificing sales to
other customers, then the lowest and highest
possible transfer prices are computed as
follows:
a. The lowest acceptable transfer price,
as determined by the seller, is $10.
b. The highest acceptable transfer price,
as determined by the buyer, is $20.
c. Therefore, the range of acceptable
transfer prices is $10-$20.
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3. If WCP has no idle capacity and must
sacrifice other customer orders (1,000
crates) to meet the demands of Grocery
Mart (1,000 crates), then the lowest and
highest possible transfer prices are
computed as follows:
a. The lowest acceptable transfer price,
as determined by the seller, is $25.
b. The highest acceptable transfer price,
as determined by the buyer, is $20.
c. Therefore, there is no range of
acceptable transfer prices.
d. This is a desirable outcome for
Grocery Storehouse because it would
be illogical to give up sales of $25 to
save costs of $20.
4. If WCP has some idle capacity (500
crates) and must sacrifice other customer
orders (500 crates) to meet the demands of
Grocery Mart (1,000 crates), then the lowest
and highest possible transfer prices are
computed as follows:
a. The lowest acceptable transfer price,
as determined by the seller, is $17.50.
b. The highest acceptable transfer price,
as determined by the buyer, is $20.
c. Therefore, the range of acceptable
transfer prices is $17.50-$20.
iii. Evaluation of negotiated transfer prices
1. If a transfer within the company would
result in higher overall profits for the
company, there is always a range of transfer
prices within which both the selling and
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buying divisions would have higher profits
if they agree to the transfer.
2. Nonetheless, if managers are pitted against
each other rather than against their past
performance or reasonable benchmarks, a
noncooperative atmosphere is almost
guaranteed. Thus, negotiations often break
down even though it would be in both
parties’ best interests to agree to a transfer
price.
3. Given the disputes that often accompany the
negotiation process, most companies rely
on some other means of setting transfer
prices.
C. Transfers at the cost to the selling division
i. Many companies set transfer prices at either
the variable cost or full (absorption) cost
incurred by the selling division. The drawbacks
of this approach include:
1. Using full cost as a transfer price can lead to
suboptimization because it does not
distinguish between variable costs, which
may be relevant to the transfer pricing
decision, and fixed costs, which may be
irrelevant.
2. If cost is used as the transfer price, the
selling division will never show a profit on
any internal transfer. The only division
that shows a profit is the division that makes
the final sale to an outside party.
3. Cost-based transfer prices do not provide
incentives to control costs. If the actual
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costs of one division are passed on to the
next, there is little incentive for anyone to
work on reducing costs.
D. Transfers at market price
i. 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. A market-based transfer price:
1. Works best when the product or service is
sold in its present form to outside customers
and the selling division has no idle capacity.
a. With no idle capacity the real cost of
the transfer from the company’s
perspective is the opportunity cost of
the lost revenue on the outside sale.
2. Does not work well when the selling
division has idle capacity. In this case,
market-based transfer prices are likely to be
higher than the variable cost per unit of the
selling division. Consequently, the buying
division may make pricing and other
decisions based on incorrect, market-based
cost information rather than the true variable
cost incurred by the company as a whole.
E. Divisional autonomy and suboptimization
i. The principles of decentralization suggest that
companies should grant managers autonomy
to set transfer prices and to decide whether to
sell internally or externally.
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ii. While subordinate managers may occasionally
make suboptimal decisions, top managers
should allow their subordinates to control
their own destiny – even to the extent of
granting subordinate managers the right to
make mistakes.
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