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Chapter 19 – Strategic Performance Measurement: Investment Centers
correct incentive, from the standpoint of the organization as a whole: subunit 2 will reject the
special (supplemental) offer of $240 per unit from an external buyer. As such, subunit 1 would
sell in the external market. Both it and the firm as a whole are better off by $25/unit (i.e., $125
– $100).
Figure 3 illustrates a situation where there are internal cost savings (here, $16 of selling &
distribution cost savings per unit) when subunit 1 sells internally rather than externally;
unit, rather than the external market price, would in fact induce the correct economic decision
5. Finally, market prices may fluctuate significantly and continually over time (because of market
conditions—by definition), thereby requiring the organization to constantly reevaluate its
decisions (sell internally or sell externally).
Disadvantages
1. An established market price may not exist for an intermediate good/service.
2. May, in the short run, induce suboptimal decision-making (particularly when excess [i.e., idle]
market price, etc.
Cost-Based Transfer Prices
Advantages
2. Some might argue that cost information is “objective.”
Disadvantages
1. There is no singular, best definition of “cost.” Cost can be defined as: variable (or, incremental)
or full, standard or actual, and pure cost versus cost-plus.
economic decisions, but if used in its pure form would not provide any profit or mark-up to the
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Chapter 19 – Strategic Performance Measurement: Investment Centers
nonlinear cost functions makes the problem intractable.
5. If marginal costing is used to set transfer prices, there may be disincentives for
6. The use of full-cost transfer prices may avoid some of incentive problems associated with the
use of marginal (variable) costs. However, when this is the case, suboptimal decisions can
arise when the buying/purchasing subunit treats such costs as incremental—which we know
scheme.
Negotiated Transfer Prices
In some sense, and this is true particularly when divisions (subunits) within an organization operate
autonomously and independently, allowing divisions to negotiate a transfer price creates a “market
within the company.” That is, it produces results that approximate the financial results that would be
can more reflect the negotiating skills of the parties rather than optimum resource allocation and
decision making. These problems are intensified to the extent that market prices do not exist for the
goods or services transferred internally.
Summary: as can be seen from the discussion in the article, and the comments above, transfer prices
serve different purposes: profit allocation (among subunits)—a feedback or control purpose, and
providing incentives for sub-unit managers to make decisions that are in the best interest of the
organization as a whole—a decision-making purpose. Further, transfer prices affect cash flows because
of income tax considerations, which are particularly pertinent in an international context. Finally, a
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Chapter 19 – Strategic Performance Measurement: Investment Centers
19-7: “Multinational Transfer Pricing: Management Accounting Theory
versus Practice,” by Laurel Adams and Ralph Drtina, Management Accounting
Quarterly (Fall 2010), pp. 20-31.
Management accounting has traditionally used a theoretical, economics-based approach for determining
transfer prices. Nevertheless, international tax law requires that transfer prices be based on an arm’s-
length standard. This article compares the consequences of setting transfer prices under these two
approaches, which are dependent on whether the selling division is operating at or below full capacity. To
ensure that tax compliance obligations are considered when establishing transfer prices, we recommend
that the theoretical approach be modified such that there is no adjustment for capacity utilization. This
represents a significant shift in the traditional approach to teaching transfer pricing.
Discussion Questions
1. Provide an overview of the primary thesis (argument) raised by the authors of this manuscript.
This article points to a possible inconsistency in terms of the setting of transfer prices in theory (i.e., in
the literature of management accounting) versus actual practice (i.e., based on international tax law).
In terms of the former, transfer prices should be set to maximize economic efficiency; as such, we can
characterize this as an economics-based approach. In terms of the latter, tax authorities (increasingly
that the theory-based approach be modified to ignore the issue of capacity utilization.
2. How, specifically, does the issue of capacity utilization affect the theoretically appropriate
transfer price (i.e., the transfer price that leads to economic efficiency for the firm as a whole)?
The basic model is that the relevant transfer price for short-term decision-making is equal to the
“general model” shown in Chapter 19 of the text: incremental (i.e., out-of-pocket) costs + opportunity
cost, if any. (Also as noted in the text, this general model establishes the floor for the appropriate
transfer price. That is, it establishes the minimum transfer price that would help ensure profit
maximization for the firm as a whole.)
Selling/Producing Division is Operating at Less than Capacity
In this case, by definition “opportunity costs” of the selling division are zero. Thus, the minimum
transfer price would be incremental cost (which is usually, but not necessarily, the variable cost
incurred by the producing division). Of course, at this minimum price the producing division would
Selling/Producing Division is Operating at Capacity
In this case, the market price provides both the correct “signal” for economic decision making and
maintains decision-making authority on the part of subunits. If there are internal cost savings
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Chapter 19 – Strategic Performance Measurement: Investment Centers
3. Provide an overview of legal imperatives regarding transfer pricing in an international context.
Because of differential income-tax rates across countries, opportunities for minimizing world-wide
taxes (and maximizing both after-tax income and cash flow for an organization) exist through the
transfer-pricing mechanism. Essentially, the goal (from a planning, and tax, standpoint) is to attempt to
“relocate” profits of the firm to low-tax jurisdictions. (High transfer prices to a purchasing/buying unit
in Tables 1 and 2 of the article provide background information for this discussion. Table 1 assumes a
situation where the selling division is operating at capacity, while Table 2 provides data for the
situation where the selling division has excess (i.e., idle) capacity.
Taken together, these two tables lead to four possible outcomes (explored in Tables 1-4—see question
4 below). The issue then addressed by the authors is “whether the management accounting
(conceptual) approach results in transfer prices that satisfy international tax law.”
4. Provide a summary of the analysis of data reported in Tables 1, 2, 3, and 4 of the article.
Table 1 (i.e., selling division is operating at capacity): if there are no synergies (interdependencies)
between selling and buying divisions, and an external market price exists, then the economic-based
In Table 2 (i.e., selling division has excess capacity): under the economic-based approach, the selling
division would charge at a minimum a transfer price equal to its relevant cost (same as was discussed
in Chapter 11): out-of-pocket cost ($650) + Opportunity cost ($0, by definition). The maximum
transfer is allocated to the buying division.) The primary point, however, is that an arm’s length
transaction would dictate a transfer price equal to the external market price of $1,000. Anything lower
would violate the spirit if not the requirements of international tax law.
Table 3 assumes that the selling division is operating at capacity but that the circumstances for internal
versus external sales are not comparable. Here, “noncomparable” relates not to differential costs
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Chapter 19 – Strategic Performance Measurement: Investment Centers
Further, the authors suggest that this ability “to adjust for risk permits a wider range of (acceptable)
prices than used under the traditional (managerial accounting) approach where the emphasis is on
reported costs.” The example of how this ability can be used to “shift profit from a high-tax to a low-
tax jurisdiction while still satisfying the arm’s-length standard.” (See Table 3 in the article.)
Comments:
1. It is not clear what the source of this recommendation by the authors is. For example, is it the
opinion of the authors? Is it statutorily backed?
2. The choice of the $50 amount as the example offered by the authors is interesting. Might it (that is,
the low dollar amount) suggest that the leeway under the authors’ recommendation is rather limited
in terms of its impact on world-wide taxes paid?
3. It is also interesting that in discussing Table 3 the authors do not state explicitly that internal cost
savings realized because of internal transfers (i.e., situations where there are synergies associated
with internal transfers), these cost reductions can be used for tax purposes to justify a transfer price
below external market price. This possibility is not raised until later in the article when the authors
state: “As discussed in case 3, tax law allows transfer-price differences based on avoidable costs,
such as bad debts.”
In Table 4, the authors examine the situation where (similar to the case illustrated in Table 2) the
selling division is operating at less than capacity, and (similar to the case illustrated in Table 3) there
are non-comparable circumstances regarding internal versus external transfers. According to the
authors, the opportunity that exists in this context is basically the same as the case 3 (above).
A summary analysis by the authors is presented in Table 5 in the article.
5. What recommendation do the authors offer on the basis of the analysis contained in Tables 1-5
and the accompany discussion?
Table 5 indicates that in four of six situations, the theoretical (marginal costing) or managerial
accounting recommendation for setting transfer prices is inconsistent with the arm’s-length
requirement for international tax purposes. When the selling division has idle capacity, transfer prices
Given the summary in Table 5, the authors recommend that “all transfer prices be set as if the firm
were operating a fully capacity” (i.e., as if idle capacity were zero). Two justifications of this
recommendation are offered by the authors:
