Topic 5 : Internal transfer prices

 Decentralization is the delegation of decision-making

 Benefits of decentralization:
o Lower-level decision often based on better information.
o Top management freed to concentrate on strategy
o Decision-making authority leads to job satisfaction.
o Lower level managers can respond quickly to customers.

 Disadvantages of decentralization:
o Lower-level managers may make decisions without seeing the “big picture.”
o May be a lack of coordination among autonomous managers.
o Lower-level manager’s objectives may not be those of the organization.
 Three Primary Approaches :
 A transfer price is the price charged when one segment of a company provides goods or services
to another segment of the company
o Negotiated transfer prices
 Definition: discussions between the selling and buying divisions
 Advantages:
 Autonomy
 Most appropriate when managers have equal bargaining power
 Most appropriate where there are market imperfections for the
intermediate product and managers have equal bargaining power
 Disadvantages:
 Can lead to sub-optimal decisions
 Divisional profitability may be strongly influenced by the bargaining
skills and powers of the divisional managers.
 o Transfers at the cost to the selling division (or Cost-Based Prices)
 Definition: Many companies set transfer prices at either the variable cost or full
(absorption) cost incurred by the selling division.
 Disadvantages:
 The selling division will never show a profit on any internal transfer.
 Cost-based transfer prices do not provide incentives to control costs.
 Doesn't reflect market conditions
o 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.
 Advantages:
 Encourages efficiency.
 Disdvantages:
 Only possible if a perfectly competitive external market exists.
 Market prices may fluctuate..

 Divisional Autonomy and Suboptimization

The principles of decentralization suggest that companies should grant managers autonomy to set
transfer prices and to decide whether to sell internally or externally, even is this may occasionally result
in suboptimal decisions.

Suboptimization occurs when different subunits each attempt to reach a solution that is optimal for that
unit, but that may not be optimum for the organization as a whole.