Methods of Transfer Pricing (4 Methods)

Management’s objective in setting a transfer price is to encourage goal congruence

among the division managers involved in the transfer.

A general rule that will ensure goal congruence is given below:

The general rule specifies the transfer price as the sum of two cost components. The first
component is the outlay cost incurred by the division that produces the goods or
services to be transferred. Outlay costs will include the direct variable costs of the
product or service and any other outlay costs that are incurred only as a result of the
transfer. The second component in the general transfer-pricing rule is the opportunity
cost incurred by the organization as a whole because of the transfer. An opportunity cost
is a benefit that is forgone as a result of taking a particular action.

Broadly, there are three bases available for determining transfer prices, but many
options are also available within each base.

These methods are:

(1) Market Prices

(2) Cost-Based Prices

(3) Negotiated Prices

(4) Dual Prices

(1) Market-Based Prices:

Market price refers to a price in an intermediate market between independent buyers
and sellers. When there is a competitive external market for the transferred product,
market prices work well as transfer prices. When transferred goods are recorded at
market prices, divisional performance is more likely to represent the real economic
contribution of the division to total company profits. If the goods can not be bought
from a division within the company, the intermediate product would have to be
purchased at the current market price from the outside market. Divisional profits are
therefore likely to be similar to the profits that would be calculated if the divisions were
separate organisations.

Consequently, divisional profitability can be compared directly with the profitability of-
similar companies operating in the same type of business. Managers of both buying and
selling divisions are indifferent between trading with each other or with outsiders. No
division can benefit at the expense of another division. In the market price situation, top
management will not be tempted to intervene.

Market-based prices are based on opportunity costs concepts. The opportunity cost
approach signals that the correct transfer price is the market price. Since the selling
division can sell all that it produces at the market price, transferring internally at a lower
price would make the division worse off.

Similarly the buying division can always acquire the intermediate goods at the market
price, so it would be unwilling to pay more for an internally transferred goods. Since the
minimum transfer price for the selling division is the market price and the maximum
price for the buying division is also the market price, the only possible transfer price is
the market price.

The market price can be used to resolve conflicts among the buying and selling
divisions. From the company viewpoint, market price is the optimal so long as the
selling division is operating at full capacity. The market price does not allow any gains or
losses in efficiency of the selling division. It saves administrative costs as the use of
competitive market prices are free from any dispute, argument and bias.

Further, transfer prices based on market prices are consistent with the responsibility
accounting concepts of profit centres and investment centres. In addition to
encouraging division managers to focus on divisional profitability, market based
transfer prices help to show the contribution of each division to overall company profit.

However, there are some problems using the market price approach:
(i) Appropriate Market Price may not Exist:
Firstly, finding a competitive market price may be difficult if such a market does not
exist. Catalogue price may only vaguely relate to actual sales prices. Market prices may
change often. Also, internal selling expenses may be less than would be incurred if the
products were sold to outsiders.
Further, the fact that two responsibility centres are parts of one company indicates that
there may be some advantages from being part of one company and not being two
separate companies dealing with each other in the market. For example, there may be
more certainty about the internal division’s product quality or delivery reliability. Or the
selling division may make a specialised product for which there are not substitutes in
the market. Hence, it may not be possible to use market prices.

(ii) Excess Production Capacity:

Another problem with market prices can occur when a selling division is not operating
at full capacity and can not sell all its products. To illustrate this point, assume that
material used by Division A in a company are being purchased from outside market at
Rs 200 per unit.

The same materials are produced by Division B. If Division B is operating at full

capacity, say of 50,000 units and can sell all its products to either Division A or to
outside huyers, then the use of transfer price of Rs 200 per unit (market price) has no
effect on Division B’s income or total company profit. Division B will earn revenue of Rs
200 per unit on all its production and sales, regardless of who buys its product and
Division A will pay Rs 200 per unit, regardless of whether it purchases the materials
from Division B or from an outside supplier. In this situation, the use of market price as
the transfer price is appropriate.

However, if Division B is not operating at full capacity and unused capacity exists in that
division, the use of market price may not lead to maximisation of total company profit.
To illustrate this point, assume that Division B has unused capacity of 30,000 units and
it can continue to sell only 50,000 units to outside buyers.

In this situation, the transfer price should be set to motivate the manager of Division A
to purchase from Division B if the variable cost per unit of product of Division B is less
than the market price. If the variable costs are less than Rs 200 per unit but the transfer
price is set equal to the market price of Rs 200, then the manager of Division A is
indifferent as to whether materials are purchased from Division B or from outside
suppliers, since the cost per unit to Division B would be the same, Rs 200.

However, Division A’s purchase of 20,000 units of materials from outside suppliers at a
cost of Rs 200 per unit would not maximise overall company profit, since this market
price per unit is greater than the unit variable cost of Division B, say Rs 100. Hence, the
intra-company transfer could save the company the difference between the market price
per unit and Division B’s unit variable expenses. This savings of Rs 100 per unit would
add Rs 20,00,000 (20,000 units X Rs 100) to overall company profit.

Transfer prices based on market prices are consistent with the responsibility accounting
concept of profit centres and investment centres. In addition to encouraging division
managers to focus on divisional profitability, market-based transfer prices help to show
the contribution of each division to overall company profit. When aggregate divisional
profits are determined for the year, and ROI and RI are computed, the use of a market
based transfer price helps to assess the contributions of each division to overall
corporate profits.

Hilton sums up difficulty associated with general rule of transfer pricing in

the following words:
(i) Difficulting in Measuring Opportunity Costs:
The general transfer-pricing rule will always promote goal-congruent decision making if
the rule can be implemented. However, the rule is often difficult or impossible to
implement due to the difficulty of measuring opportunity costs. Such a cost-
measurement problem can arise for a number of reasons. One reason is that the external
market may not be perfectly competitive. Under perfect competition, the market price
does not depend on the quantity sold by anyone producer.

Under imperfect competition, a single producer or group of producers can affect the
market price by varying the amount of product available in the market. In such cases,
the external market price depends on the production decisions of the producer. This in
turn means that the opportunity cost incurred by the company as a result of internal
transfers depends on the quantity sold externally. These interactions may make it
impossible to measure accurately the opportunity cost caused by a product transfer.

(ii) Nature of Transferred Goods:

Other reasons for difficulty in measuring the opportunity cost associated with a product
transfer include uniqueness of the transferred goods or services, a need for the
producing division to invest in special equipment in order to produce the transferred
goods, and interdependencies among several transferred products or services. For
example, the producing division may provide design services as well as production of the
goods for a buying division. What is the opportunity cost associated with each of these
related outputs of the producing division? In many such cases it is difficult to sort out
the opportunity costs.

(iii) Distress Market Prices:

Occasionally an industry will experience a period of significant excess capacity and
extremely low prices. For example, when gasoline prices soared due to a foreign oil
embargo, the market prices for recreational vehicles and power boats fell temporarily to
very low levels.

Under such extreme conditions, basing transfer prices on market prices can lead to
decisions that are not in the best interests of the overall company. Basing transfer prices
on artificially low distress market prices could lead the producing division to sell or close
the productive resources devoted to producing the product for transfer. Under distress
market prices, the producing division manager might prefer to move the division into a
more profitable product line.

While such a decision might improve the division’s profit in the short run, it could be
contrary to the best interests of the company overall. It might be better for the company
as a whole to avoid divesting itself of any productive resources and to ride out the period
of market distress. To encourage an autonomous division manager to act in this fashion,
some companies set the transfer price equal to the long-run average external market
price, rather than the current (possibly depressed) market price.

(2) Cost Based Prices:

When external markets do not exist or are not available to the company or when
information about external market prices is not readily available, companies may decide
to use some forms of cost-based transfer pricing system.

Cost-based transfer prices may be in different forms such as variable cost, actual full
cost, full cost plus profit margin, standard full cost.
(a) Variable Cost:
Variable cost-based pricing approach is useful when the selling division is operating
below capacity. The manager of the selling division will generally not like this transfer
price because it yields no profit to that division. In this pricing system, only variable
production costs are transferred. These costs are direct materials, direct labour and
variable factory overhead.
Variable cost has the major advantage of encouraging maximum profits for the entire
firm. By passing only variable costs alone to the next division, production and pricing
decisions are based on cost- volume-profit relationships for the firm as a whole. The
obvious problem is that selling division is left holding all its fixed costs and operating
expenses. That division is now a loss division, no where near a profit centre.

(b) Actual Full Cost:

In actual full cost approach, transfer price is based on the total product cost per unit
which will include direct materials, direct labour and factory overhead. When full cost is
used for transfer pricing, the selling division cannot realise a profit on the goods
transferred. This may be disincentive to the selling division. Further, full cost transfer
pricing can provide perverse incentives and distort performance measures. A full cost
transfer price would have shutdown the chances of any negotiation between divisions
about selling at transfer prices.

(c) Full Cost Plus Profit Margin:

Full cost plus mark up (or profit margin) overcomes the weaknesses of full cost basis
transfer pricing system. The full cost plus price include the allowed cost of the item plus
a mark up or other profit allowance. With such a system, the selling division obtains a
profit contribution on units transferred and hence, benefits if performance is measured
on the basis of divisional operating profits. However, the manager of the buying division
would naturally object that his costs (and hence reported performance) are adversely
affected.

The basic question in full cost plus mark up is ‘what should be the percentage of mark
up.’ It can be suggested that the mark up percentage should cover operating expenses
and provide a target return on sales or assets.

(d) Standard Costs:
In actual cost approaches, there is a problem of measuring cost. Actual cost does not
provide any incentive to the selling division to control cost. All product costs are
transferred to the buying division. While transferring actual costs any variances or
inefficiencies in the selling division are passed along to the buying division.

The problem of isolating the variances that have been transferred to subsequent buyer
division becomes extremely complex. To promote responsibility in the selling division
and to isolate variances within divisions, standard costs are usually used as a basis for
transfer pricing in cost-based systems.

Whether transferring at differential costs or full costs, standard costs, where available,
are often used as the basis for the transfer. This encourages efficiency in the selling
division because inefficiencies are not passed onto the buying division. Otherwise, the
selling division can transfer cost inefficiencies to the buying division. Use of standard
cost reduces risk to the buyer. The buyer knows that standard costs will be transferred
and avoids being charged with suppliers’ cost overruns.

(3) Negotiated Prices:

Negotiated prices are generally preferred as a middle solution between market prices
and cost- based prices. Under negotiated prices, the managers involved act much the
same as the managers of independent companies. Negotiation strategies may be similar
to those employed when trading with outside markets. If both divisions are free to deal
either with each other or in the external market, the negotiated price will likely be close
to the external market price. If all of a selling division’s output can not be sold in the
external market (that is, a portion must be sold to the buying division), the negotiated
price will likely be less than the market price and the total margin will be shared by the
divisions.

The conditions under which a negotiated transfer price will be successful

include:
1. Some Form of Outside Market for the Intermediate Product:
This avoids a bilateral monopoly situation in which the final price could vary over too
large a range, depending on the strength and skill of each negotiator.

2. Sharing of all Market Information Among the Negotiators:

This should enable the negotiated price to be close to the opportunity cost of one or
preferably both divisions.

3. Freedom to Buy or Sell Outside:

This provides the necessary discipline to the bargaining process.

4. Support and Occasional Involvement of Top Management:

The parties must be urged to settle most disputes By themselves, otherwise the benefits
of decentralization will be lost. Top management must be available to mediate the
occasional unresolvable dispute or to intervene when it sees that the bargaining process
is clearly leading to suboptimal decisions. But such involvement must be done with
restraint and tact if it is not to undermine the negotiating process.

Negotiated price avoids mistrusts, bad feelings and undesirable bargaining interests
among divisional managers. Also, it provides an opportunity to achieve the objectives of
goal congruence, autonomy and accurate performance evaluation. The overall company
is beneficiary if selling and buying divisions can agree upon some mutually transfer
prices. Negotiated transfer price is considered as a vital integrating tool among divisions
of a company which is necessary to achieve goal congruence.

If negotiations help ensure goal congruence, top management has little temptation to
intervene between divisions. The agreed prices also can be used for performance
measurement without creating any friction. The use of negotiated prices is consistent
with the concept of decentralised decision-making in the divisionalised firms.

However, negotiated prices have the following disadvantages:

(1) A great deal of management effort, time and resources can be consumed in the
negotiating process.

(2) The final emerging negotiated price may depend more on the divisional manager’s
ability and skill to negotiate than on the other factors. Thus, performance measures will
be distorted leading to incorrect evaluation of divisional performance.

(3) One divisional manager having some private information may take advantage of
another divisional manager.

(4) It is time-consuming for the managers involved.

(5) It leads to conflicts between divisions.

(6) It may lead to a suboptimal level of output if the negotiated price is above the
opportunity cost of supplying the transferred goods.

Garrison and Noreen observe:

“The difficulty is that not all managers understand their own businesses and not all
managers are cooperative. As a result, negotiations often break down even when it
would .be in the manager’s own best interest to come to an agreement. Sometimes that
is the fault of the way managers are evaluated. If managers are pitted against each other,
rather than against their own past performance or reasonable bench-marks, a non-
cooperative atmosphere is almost guaranteed. Nevertheless, it must be admitted that
even with the best performance evaluation system, some people by nature are not
cooperative.”

(4) Dual Prices:

Under dual prices of transfer pricing, selling division sells the transferred goods at a (i)
market or negotiated market price or (ii) cost plus some profit margin. But the transfer
price for the buying division is a cost-based amount (preferably the variable costs of the
selling division). The difference in transfer prices for the two divisions could be
accounted for by special centralised account. This system would preserve cost data for
subsequent buyer departments, and would encourage internal transfers by providing a
profit on such transfers for the selling divisions.

Dual prices give motivation and incentive to selling divisions as goods are transferred at
market price and this arrangement provides a minimal cost to the buying division as
well. Market price can be considered as the most appropriate base for the selling
division. Thus dual pricing-system has the function of motivating both the selling
division and buying division to make decisions that are consistent with the overall goals
of decentralisation—goal congruence, accurate performance measurement, autonomy,
adequate motivation to divisional manager.

Summary View:
Transfer pricing policy aims to drive the divisions, who are more inclined to act in their
individual self interest and consider their own costs, prices and market opportunities,
toward behaviour that is best for the organization. Economies of scale, synergies and
saving transaction costs motivate divisional managers to conduct transactions within
the company rather than using market-based transactions with external supplier and
customers.

In reality, no particular transfer pricing system can be suggested for all decentralised
companies as no one transfer price will be helpful to them in achieving all their goals
and objectives. The divisionalised companies should first determine their goals and
priorities before selecting a transfer pricing.
Therefore, the transfer pricing methods selected by a particular business enterprise
must reflect the requirements and characteristics of that enterprise and must ultimately
be judged by the decision making behaviour that it motivates. Anderson and
Sollenberger have presented their evaluation of different transfer pricing approaches as
displayed Exhibit 12.1.

Kaplan and Atkinson have given the following recommendations in

choosing a transfer pricing practice:
1. Where a competitive market exists for the intermediate product, the market price, less
selling, distribution, and collection expenses for outside customers, represents an
excellent transfer price.

2. Where an outside market exists for the intermediate product but is not perfectly
competitive and where a small number of different products are transferred, a
negotiated-transfer- price system will probably work best, since the outside market price
can serve as an approximation of the opportunity cost. At least occasional transactions
with outside suppliers and customers must occur if both divisions are to have credibility
in the negotiating process and if reliable quotes from external firms are to be obtained.

3. When no external market exists for the intermediate product, transfers should occur
at the long-run marginal cost of production. This cost will facilitate the decision making
of the purchasing division by providing the stability needed for long-run planning but at
the same time exposing the cost structure so that short-run improvements and
adjustments can be made. A periodic fixed fee based on capacity reserved for the buying
division is incorporated in the marginal cost calculation.

The fixed fee, ideally based on product and facility-sustaining costs from an ABC model,
should allocate the capacity-related costs of the facility in proportion to each user’s
planned use of the facility’s resources. The fixed fee forces the purchasing division to
recognize the full cost of the resources required to produce the intermediate product
internally, and it provides a motivation for the producing divisions to cooperate in
choosing the proper level of productive capacity to acquire.

4. A transfer price based on fully allocated costs per unit (using present, that is, non-
ABC, methods of allocation) or full cost plus markup has no discernible desirable
properties. Although the full-cost transfer price, has limited economic validity, it
remains widely used. The marginal cost calculated from an ABC model does provide the
capability for managers to use a full-cost approach that is consistent with economic
theory.