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At the end of this lecture, the student should be able to:

LO 1: Describe the different purposes of transfer prices
LO 2: Be able to determine the transfer price using the different methods
LO 3: Identify and describe alternative pricing methods
LO4: Explain what the optimal transfer price will be
LO5: Explain how a transfer price can resolve conflicts between management
and lead to goal congruence and correct decision making
LO6: Explain how the transfer price is linked to performance evaluation
Transfer Pricing

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Readings: Management and Cost Accounting

Colin Drury , Chapter 20
Part Four:
Tutorial Questions: Information for planning, control and performance

Chapter Twenty:
Notes and slides courtesy of Management and Cost Transfer pricing in divisionalized companies
Accounting: Tenth edition

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20.1a 20.1b

Purposes of transfer pricing Information for making good decisions

1. To provide information that motivates divisional managers to make good • Intermediate products = Goods transferred from the supplying to receiving division.
economic decisions. • Final products = Products sold by the receiving division to the outside world

2. To provide information that is useful for evaluating the managerial and • Example
economic performance of the divisions. Incremental cost of making intermediate product = R100
Incremental further processing costs in receiving division = R60
3. To intentionally move profits between divisions or locations. Market price of final product = R200
No external market for the intermediate product and spare
capacity
4. To ensure that divisional autonomy is not undermined. Cost-plus 50% transfer price = R150
Business will be rejected if TP set at R150

20.1c 20.2a

Alternative transfer pricing methods

1. Market-based
Evaluating managerial performance 2. Marginal cost
3. Full cost
• TP of £60 incremental cost of supplying division would motivate correct 4. Cost-plus a mark-up
decision but it does not form a basis for measuring the performance of the 5. Negotiated transfer prices
Exists in which products sold
are identical and no individual
buyer or seller can affect
market prices

supplying division.
Market-based transfer prices
• A conflict of objectives exists which can be difficult to resolve.
• 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

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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.
Net Marginal revenue!

20.2b 20.2b
The additional
cost of one
extra unit of
output

Marginal cost transfer prices 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 (see Figure 1 on slide
20.3).
• 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.
• MC not widely used:
1. Provides poor information for performance evaluation
2. MC may not be constant over entire range of output
3. Measuring MC beyond short-term is difficult
4. Managers reject short-term perspective

• When the market for the intermediate product is imperfect or non

existent, TPs set at the variable/marginal cost of the supplying division
can motivate the supplying and receiving division to operate at output
levels that maximise overall company profits.

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20.4a 20.4b

Negotiated transfer prices

Full cost transfer prices • Most appropriate where there are market imperfections for the
intermediate product and managers have equal bargaining power.
• Widely used because managers require an estimate of long-run marginal
cost for decision-making.
• To be effective managers must understand how to use cost and revenue
• Traditional costing systems tend to provide poor estimates of long run
information.
MC.
• Does not enable supplying division to report a profit on goods
• Claimed behavioural advantages.
transferred.
• Limitations:
Cost-plus a mark-up transfer prices
1. Can lead to sub-optimal decisions
• Attempts to meet the performance evaluation purpose of transfer pricing 2. Time-consuming
(profit allocated to the supplying division) 3. Divisional profitability may be strongly influenced by the bargaining
• Results in non-optimal decisions (see Figure 1 - slide 7) because TP skills and powers of the divisional managers.
exceeds short-run or long-run MC. 4. Inappropriate in certain circumstances (e.g. no market for the
• Enormous mark-ups can result when goods/services are transferred intermediate product or an imperfect market exists).
between several divisions.

20.5 20.3
Figure 1 An illustration of cost-based transfer prices
Defined as the contribution
foregone by the supplying div
from transferring internally

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
• 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.
•VERY NB-CAPACITY!!!!!!!

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20.6 20.7a

Example
Oslo = Supplying division (No external market for the intermediate product)
Bergen = Receiving division (converts intermediate to final product)

Expected sales of the final product:

Net selling price Quantity sold
(£) Units
100 1 000
90 2 000
80 3 000
70 4 000
60 5 000
50 6 000
The costs of each division are:
Oslo Bergen
(£) (£)
Variable cost per unit 11 7
Fixed costs attributable to the
products 60 000 90 000

The transfer price of the intermediate product has been set at £35 based on a full cost plus mark-up.

20.7b 20.7c

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20.8a 20.8b
• At £11 TP receiving division will choose to expand output to 5,000 units.

• £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).

• The receiving division will face the following net marginal revenue (NMR)
schedule:
• Consider a full cost TP without a mark-up (£23 if the denominator level to
Units net marginal revenue (£) compute unit fixed costs is 5,000 units)
1 000 93 000 (100 000 – 7000)
2 000 73 000 (80 000 – 7 000) The receiving division manager will choose to produce 4,000 units
3 000 53 000 (60 000 – 7 000)
4 000 33 000 (40 000 – 7 000) • Negotiation:
5 000 13 000 (20 000 – 7 000) 1. No external market so supplying division manager has little bargaining power
6 000 –7 000 (0 – 7 000) .
2. Could avoid £60,000 fixed costs so would look for a TP of at least £23 per unit
(assuming a denominator level of 5,000 units is used).

20.9a 20.9a

• Negotiation: Resolving transfer pricing conflicts

1.No external market so supplying division manager has little
bargaining power . Two approaches advocated:
2.Could avoid £60,000 fixed costs so would look for a TP of at least
£23 per unit (assuming a denominator level of 5,000 units is used). 1. Adopt a dual rate TP system
2. Transfer at MC plus a lump sum fee

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20.9b 20.9a

Resolving transfer pricing conflicts (contd.)

Resolving transfer pricing conflicts
Dual rate TP system
Dual Rate:
• Uses two transfer prices Supplying div: Variable costs of 10 per unit
1. Supplying division may receive full cost plus a mark-up so that it makes a Receiving div: Conversion costs of 30 per unit
profit on inter-divisional transfers (e.g Oslo TP > £23). Use 100 000 units as an example
2. Receiving division charged at MC of transfers thus motivating managers
to operate at the optimum output level for the company as a whole.
3. Profit on inter-group trading removed by an accounting adjustment.

• Not widely used because:

1. Use of two TP ’s causes confusion
2. Seen as artificial
3. Divisions protected from competition
4. Reported inter-divisional profits can be misleading

20.9a 20.9c
Resolving transfer price conflicts (contd.)

Resolving transfer pricing conflicts Marginal cost plus a lump sum fee
Dual Rate:
Supplying Div: VC + mark up of 50% • Where the market for the intermediate product is imperfect or non existant and
Receiving Div: Receives at VC where the supplying div has no capacity constraints.

• Intended to motivate receiving division to equate MC of transfers with its net

marginal revenue to determine optimumm 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.

• 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).

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20.10a 20.10b

Domestic TP conclusions/recommendations
• Competitive market for the intermediate product — Use market prices. Lets do IM20,5 as a class example

• 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-why? Cant pass on costs of inefficiencies
to receiving division.

20.11a

ECONOMIC THEORY OF TRANSFER PRICING

(Appendix 20.1)

Theoretically correct transfer price to encourage total organisational

optimality is, in the absence if capacity constraints, the marginal cost of
producing the intermediate product at the optimum output level for the
company as a whole.

Knowing why is complex and this economic theory is not part of this
syllabus.