Unit 3 Transfer

pricing in
divisionalized
Advanced Cost and Management
companies
Accounting

Purposes of transfer pricing

To provide information that motivates divisional

managers to make good economic decisions.

To provide information that is useful for evaluating

the managerial and economic performance of the
divisions.

To intentionally move profits between divisions or

locations.

To ensure that divisional autonomy is not

undermined.

Alternative transfer pricing

methods

Market-based

Marginal cost

Full cost

Cost-plus a mark-up

Negotiated transfer prices

Market-based transfer prices

Where there is a perfectly competitive market

for the intermediate product, the current
market price is the most suitable basis for
setting the transfer prices.

TP s will motivate sound decisions and form

a suitable basis for performance evaluation

Marginal cost transfer prices

Economic theory indicates TP based on the

MC of producing the intermediate product at
the optimum output level for the company as
a whole will encourage total organizational
optimality.

Adopting a short-run perspective to derive

MC results in MC = VC and the assumption
that MC is constant per unit throughout the
relevant output range.

Marginal cost transfer prices

Marginal Cost is not widely used:
Provides poor information for performance
evaluation
MC may not be constant over entire range of
output
Measuring MC beyond short-term is difficult
Managers reject short-term perspective

Full cost transfer prices

Widely used because managers require an

estimate of long-run marginal cost for
decision-making.

Traditional costing systems tend to provide

poor estimates of long run MC.

Does not enable supplying division to report

a profit on goods transferred.

Cost-plus a mark-up transfer

prices

Attempts to meet the performance evaluation

purpose of transfer pricing (profit allocated to
the supplying division)

Results in non-optimal decisions because TP

exceeds short-run or long-run MC.

Enormous mark-ups can result when

goods/services are transferred between
several divisions.

Negotiated transfer prices

Most appropriate where there are market

imperfections for the intermediate product
and managers have equal bargaining power.

To be effective managers must understand

how to use cost and revenue information.

Claimed behavioural advantages.

Negotiated transfer prices

Limitations:

Can lead to sub-optimal decisions

Time - consuming

Divisional profitability may be strongly

influenced by the bargaining skills and
powers of the divisional managers.

Inappropriate in certain circumstances (e.g.

no market for the intermediate product or an
imperfect market exists).

Marginal cost plus

opportunity cost

Often cited as a general rule that will lead to

optimal decisions for the company as a
whole.

Where there is no intermediate market the

application of the rule leads to TP = VC
(assuming VC = MC)

Marginal cost plus

opportunity
cost
Where there is a perfect market for the

intermediate product the application of the

rule leads to TP = MP
(e.g. market price = 20 and VC = 5)

TP = $5VC + $15 opportunity cost = 20

Rule tends to be a restatement of the

general principles previously established and
it is also difficult to apply in more complex
situations.

Transfer Pricing Conflicts

Lecture Question 1

Companys Profit

Profit for the Supplying Division (Oslo)

Profit for the Receiving Division (Bergen)

Illustration

Illustration

Illustration

Discussion

$35 TP does not motivate optimum output

level for the company as a whole.

To ensure overall company optimality the TP

must be set at MC of the intermediate
product (i.e. VC of $11 per unit or $11,000 per
batch of 1,000 units).

At $11 TP receiving division will choose to

expand output to 5,000 units.

Discussion

Consider a full cost TP without a mark-up

($23 if the denominator level to compute unit
fixed costs is 5,000 units)

The receiving division manager will choose to

produce 4,000 units

Negotiation if there is no external market

the supplying division manager has little
bargaining power

Resolving transfer pricing

conflicts
Two approaches advocated:

Adopt a dual rate TP system

Transfer at MC plus a lump sum fee

Dual rate TP system

Uses two transfer prices

Supplying division may receive full cost plus

a mark-up so that it makes a profit on interdivisional transfers (e.g. Oslo TP > $23).

Receiving division charged at MC of

transfers thus motivating managers to
operate at the optimum output level for the
company as a whole.

Profit on inter-group trading removed by an

accounting adjustment.

Dual rate TP system

Not widely used because:
Use of two TP s causes confusion
Seen as artificial
Divisions protected from competition
Reported inter-divisional profits can be
misleading

Marginal cost plus a lump

sum fee

Intended to motivate receiving division to

equate MC of transfers with its net marginal
revenue to determine optimum company
profit maximizing output level.

Enables supplying division to cover its fixed

costs and earn a profit on inter-divisional
transfers through the fixed fee charged for
the period.

Marginal cost plus a lump

sum fee

Motivates receiving division to consider full

cost of providing intermediate
products/services (TP = $11 MC plus $60,000
lump sum plus a profit contribution in the
example).

Domestic TP conclusions or
recommendations

Competitive market for the intermediate

product Use market prices.

No market for the intermediate product or an

imperfect market Transfer at MC plus a
lump sum or negotiation may be appropriate
in certain circumstances.

Use standard costs for cost-based TP s

International transfer pricing

Where divisions are located in different

countries taxation implications become
important and TP has the potential to ensure
that most of the profits on inter-divisional
transfers are allocated to the low taxation
country.

Example

Supplying division in country A (Tax rate = 25%)

Receiving division in country B (Tax rate = 40%)

Discussion:
Motivation is to use highest possible TP so receiving
division will have high costs and low profits whereas
supplying division will have high revenues and high
profits.

Example

Taxation authorities in most countries are

wise to companies using TP to manipulate
profits and seek to apply OECD guidelines
based on arm s length pricing principles.

TP can also have an impact on import duties

and dividend repatriations.

Sellers Minimum Price

Transfer Price = outlay cost + opportunity

cost

Outlay cost relevant cost to supply

commodity to the buying division.

Opportunity cost any sacrifice the seller will

have to make to supply commodities to the
buying division.

Lecture Question 2

Buyers Maximum Price

TP = SP VCU excluding transferred item

relevant FCU; but not higher than market
price.

Lecture Question 3

Reference
Management and Cost Accounting 7e by Colin
Drury ISBN 9781844805662