Transfer Pricing

Key Concepts/Definitions
A transfer price is the price
charged when one segment
of a company provides
goods or services to
another segment of the
company.

The fundamental objective

in setting transfer prices is
to motivate managers to
act in the best interests of
the overall company.

Transfer Pricing

The amount charged when one division sells

goods or services to another division

Batteries
Battery Division

Auto Division

Three Primary Approaches

There are three primary
approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.

Negotiated Transfer Prices

A negotiated transfer price results from discussions
between the selling and buying divisions.
Range of Acceptable
Transfer Prices
Upper limit is
determined by the
buying division.

Lower limit is
determined by the
selling division.

Barker Company An Example

Assume the information as shown with respect
to The Battery Division and Vehicle Division
(both Divisions are owned by Barker
Company).

Barker Company Scenario 1

Suppose that the Battery Division is operating at

capacity.
What is the lowest acceptable transfer price from the
viewpoint of the Battery Division?
What is the highest acceptable transfer price from
the viewpoint of the Vehicle Division?
Will a transfer take place?

General Guideline for Determining

a Minimum Transfer Price

Minimum transfer price

= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division

Barker Company Scenario 1

As indicated, the Battery Division is operating at capacity. The Battery
Divisions acceptable transfer price is calculated as:

The Vehicle Divisions acceptable transfer price is calculated as:

Barker Company Scenario 1

If Battery Division has no idle capacity (0 batteries) and must sacrifice other
customer orders (50,000 batteries) to meet Vehicle Divisions demands
(50,000 barrels), then the lowest and highest possible transfer prices are
computed as follows:
Selling divisions lowest possible transfer price:

Buying divisions highest possible transfer price:

Therefore, there is no range of acceptable

transfer prices.

Barker Company Scenario 2

Refer to the original data. Assume that the

Battery Division has enough idle capacity to supply the
Vehicle Divisions needs without diverting batteries
from the outside market.
What is the lowest acceptable transfer price from
the viewpoint of the Battery Division? In what price
range will a transfer take place?

Barker Company Scenario 3

Refer to the original data. Suppose the Battery Division is
selling 275,000 batteries per month on the outside market. The
Vehicle Division can put only one kind of batteries in its vehicles.
It cannot buy 25,000 batteries from an outside supplier and
25,000 batteries from the Battery Division: it must buy all of its
batteries from one source. The Battery Division must sacrifice
some outside customer orders to meet the Vehicle Divisions
demands.
What is the lowest acceptable transfer price from the
viewpoint of the Battery Division? In what price range will a
transfer take place? Is this transfer goal-congruent for the
Company (Barker)?

An Example
Materials used by the Truck Division of Structure Motors are currently
purchased from outside suppliers at a cost of $260 per unit. However, the
same materials are available from the Component Division. The
Component Division has unused capacity and can produce the materials
needed by the Truck Division at a variable cost of $190 per unit.
a.

If a transfer price of $230 per unit is established and 40,000 units of

material are transferred with no reduction in the Component Divisions
current sales, how much would Structure Motors total income from
operations increase?

b. How much would the Truck Divisions income from operations increase?
c.

How much would the Component Divisions income from operations

increase?

d. Lets change the transfer price to $250. Recalculate a, b and c above.

What additional insights can we gain?

Evaluation of Negotiated Transfer

Prices
If a transfer within a company would result in
higher overall profits for the company, there is
always a range of transfer prices within which
both the selling and buying divisions would
have higher profits if they agree to the
transfer.

Cost-Based Transfer Prices

Some companies use the following measures of cost to

establish transfer prices . . .
Variable cost (18 for the Battery Division). The selling
division will never show a profit on any internal
transfer.
Full absorption cost (25 for the Battery Division)
Will the Battery Division transfer at Full Cost if it has no
capacity?
What happens if the Battery Division has capacity and
the Auto Division can sell batteries at 23 in a
foreign country?
Mark-up (e.g. 120% of full cost, or 30 per battery).

Transfers at Market Price

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.
Note:

1. A market price approach works best when the product or

service is sold in its present form to outside customers and
the selling division has no idle capacity. In the Battery
Division example, the price would be set at 40.

2. A market price approach does not work well when the

selling division has idle capacity. What happens if the
Battery Division has excess capacity? Will it prefer to sell at
a price below 40?

An International Perspective
Since tax rates are different in different countries, companies
have incentives to set transfer prices that will:
Increase revenues in low-tax countries.
Increase costs in high-tax countries.