Many organizations sell their own products internally, from one division to another. This is especially common in vertically integrated situations, where a company has elected to control the key pieces of its supply chain, perhaps to lock down the supply of key components. Each division sells its products to a downstream division that includes those products in its own production processes. When this happens, management must determine the prices at which components will be sold between divisions. This is known as “TRANSFER PRICING“. This post provides best practice by answering the following questions: When Is Transfer Pricing Important? How Do Transfer Prices Alter Corporate Decision Making? And, What Transfer Pricing Method Should I Use? We will open the discussion with the first question. Move on…
When Is Transfer Pricing Important?
Transfer pricing levels are very important in companies experiencing any of the following three transfers or operational characteristics:
- High volumes of interdivisional sales. This is most common in vertically integrated companies, where each division in succession produces a component that is a necessary part of the product being created by the next division in line. Any incorrect transfer pricing in this scenario can cause considerable dysfunctional purchasing behavior.
- High volumes of segment-specific sales. Even if a company as a whole does not transfer much product between its divisions, this does not mean that specific departments or product lines within each division do not have a much higher dependence on the accuracy of transfer pricing for selected products.
- High degree of organizational decentralization. If an organization is arranged under the theory that divisions should operate as independently as possible, then they will have no incentive to work together unless the transfer prices used are set at levels that give them an economic incentive to do so.
Alternatively, the theoretical foundation for the calculation of transfer prices is of little importance for those organizations with a high degree of centralization, for individual divisions will be ordered by the headquarters staff to produce and transfer products to other divisions irrespective of the prices charged. This is also the case for companies that rarely transfer any products among their divisions, for such transfers, when they occur, are typically approved at the highest management levels if the transfers either are large or are so small that their impact is minimal.
How Do Transfer Prices Alter Corporate Decision Making?
A company must set its transfer prices at levels that will result in the highest possible levels of profits, not for individual divisions but rather for the entire organization.
Example: If a transfer price is set at nothing more than its cost, the selling division would much rather not sell the product at all, even though the buying division can sell it externally for a huge profit that more than makes up for the lack of profit experienced by the division that originally sold it the product.
The typical division manager will select the product sales that result in the highest level of profit for only his or her division, since the manager has no insight into (or interest in) the financial results of the rest of the organization. Only by finding some way for the selling division to also realize a profit will it have an incentive to sell its products internally, thereby resulting in greater overall profits. An example of such a solution is when a selling division creates a byproduct that it cannot sell but that another division can use as an input for the products it manufactures. The selling division scraps the byproduct, because it has no incentive to do anything else with it. However, by assigning the selling division a small profit on sale of the byproduct, it now has an incentive to ship it to the buying division. Such a pricing strategy assists a company in deriving the greatest possible profit from all of its activities.
Another factor is that the amount of profit allocated to a division through the transfer pricing method used will impact its reported level of profitability and therefore the performance review for that division and its management team:
- If the management team is compensated in large part through performance-based bonuses, then its actions will be heavily influenced by the profit it can earn on inter-company transfers, especially if such transfers make up a large proportion of total divisional sales.
- If transfer prices are set at very high levels, this can result in the manufacture of far more product than is needed, which may lock up so much production capacity that the selling division is no longer able to create other products that could otherwise have been sold for a profit.
- Conversely, an excessively low transfer price will result in no production at all, as long as the selling division has some other product available that it can sell for a greater profit. This latter situation frequently results in late or small deliveries to buying divisions, since the managers of the selling divisions see fit to produce low-price items only if there is spare production capacity available that can be used in no other way. Thus, improper transfer prices will motivate division managers in accordance with how the prices impact their performance evaluations.
- Finally, altering the transfer price used can have a dramatic impact on the amount of income taxes a company pays, if it has divisions located in different countries that use different tax rates. All of these issues must be considered when selecting an appropriate transfer pricing method.
Companies that are frequent users of transfer pricing must create prices that are based on a proper balance of the goals of overall company profitability, divisional performance evaluation, simplicity of use, and (in some cases) the reduction of income taxes. The attainment of all these goals by using a single transfer pricing method is not common, and should not be expected. Instead, managers must focus on the attainment of the most critical goals, while keeping the adverse affects of not meeting other goals at a minimum. This process may result in the use of several transfer pricing methods depending on the circumstances surrounding each interdivisional transfer.
What Transfer Pricing Method Should I Use?
Through this section, we are going to discuss about various transfer pricing methods, its concept and approaches. Each method comes with its strength-weakness. By knowing its strength and weakness, we can wisely select and implement the most suitable for our business. They also come with some idea of best practices to get the most out of each method.
External Market Price
The most commonly used transfer pricing technique is based on the existing external market price. Under this approach, the selling division matches its transfer price to the current market rate. By doing so, a company can achieve a number of goals:
- First, it can achieve the highest possible corporate wide profit. This happens because the selling division can earn just as much profit by selling all of its production outside of the company as it can by doing so internally; there is no reason for using a transfer price that results in incorrect behavior of either selling externally at an excessively low price or selling internally when a better deal could have been obtained by selling externally.
- Second, using the market price allows a division to earn a profit on its sales, no matter whether it sells internally or externally. By avoiding all transfers at cost, the senior management group can structure its divisions as profit centers, thereby allowing it to determine the performance of each division manager.
- Third, the market price is simple to obtain—it can be taken from regulated price sheets, posted prices, or quoted prices, and applied directly to all sales. No complicated calculations are required, and arguments over the correct price to charge between divisions are kept to a minimum.
- Fourth, a market-based transfer price allows both buying and selling divisions to shop anywhere they want to buy or sell their products. For example, a buying division will be indifferent as to where it obtains its supplies, for it can buy them at the same price regardless of whether that source is a fellow company division. This leads to a minimum of incorrect buying and selling behavior that would otherwise be driven by transfer prices that do not reflect market conditions.
For all these reasons, companies are well advised to use market-based transfer prices whenever possible.
Unfortunately, many corporations do not use market-based transfer pricing, not because they do not want to, but because there are no market prices available. This happens when the products being transferred do not exactly match those sold on the market, or if they are intermediate-level products that have not yet been converted into final products, so there is no market price available for them. Another problem with market-based pricing is that there must truly be an alternative for a selling division to sell its entire production externally.
This is a common problem for specialty products, where the number of potential buyers is small and their annual buying needs limited in size. A final issue is that market-based pricing can drive divisions to sell their production outside of the company. This problem arises in tight supply situations, where a buying division cannot obtain a sufficient amount of parts from a selling division because it is selling them externally. In this case, the selling division is maximizing its own profit at the expense of divisions that need its output. This is particularly important when the buying division adds so much value to the product that it can then sell it externally at a much higher margin than could the selling division.
Adjusted Market Price
Another approach is adjusted market pricing, where prices are set in order to simplify transfer prices and adjust for the absence of sales-related costs.
Example: If market prices vary considerably by the unit volume ordered, there may be a broad range of transfer prices in use, which can be very complicated to track. A single adjusted market price can be used instead, which is based on the average shipment or order size. If a buying division turns out to have purchased in significantly different quantities than the ones that were assumed at the time prices were set, then a company can retroactively adjust transfer prices at the end of the year; or it can leave the pricing alone and let the divisions do a better job of planning their interdivisional transfer volumes in the next year.
As another example: there should be no bad debts when selling between divisions, as opposed to the occasional losses incurred when dealing with outside firms; accordingly, this cost can be deducted from the transfer price. The same argument can be made for the sales staff, whose services are presumably not required for interdepartmental sales. However, these price adjustments are subject to negotiation, so more aggressive division managers are more likely to resist reductions from their market-based prices, while those managing the buying divisions will push hard for excessively large price deductions. The result may be pricing anomalies that do not yield the optimum profit for the company as a whole.
Negotiated Transfer Price
Another option is to use negotiated transfer prices. Under this technique, the managers of buying and selling divisions negotiate a transfer price between themselves, using a product’s variable cost as the lower boundary of an acceptable negotiated price, and the market price (if one is available) as the upper boundary.
The price that is agreed upon, as long as it falls between these two boundaries, should give some profit to each division, with more profit going to the division with better negotiating skills. The method has the advantage of allowing division managers to operate their businesses in a more independent manner, not relying on preset pricing. It also results in better performance evaluations for those managers with greater negotiation skills. However, it also suffers from some flaws. First, if the negotiated price excessively favors one division over another, the losing division will search outside the company for a better deal on the open market, and will direct its sales and purchases in that direction; this may result in suboptimal companywide profitability levels. Also, the negotiation process can take up a substantial portion of a manager’s time, not leaving enough for other management activities. This is a particular problem if prices require constant renegotiation. Finally, the interdivisional conflicts over negotiated prices can become so severe that the problem is kicked up corporate headquarters, which must step in and set prices that the divisions are incapable of determining by themselves. For all these reasons, the negotiated transfer price is a method that is generally relegated to special or low-volume pricing situations.
Contribution Margin Approach
What if there is no market price at all for a product? A company then has no basis for creating a transfer price from any external source of information, so it must use internal information instead.
One approach is to create transfer prices based on a product’s contribution margin. Under this pricing system, a company determines the total contribution margin earned after a product is sold externally, and then allocates this margin back to each division based on their respective proportions of the total product cost. There are several good reasons for using this approach. They are:
Converts a cost center into a profit center. By using this method to assign profits to internal product sales, divisional managers are forced to pay stricter attention to their profitability, which helps the overall profitability of the organization.
Encourages divisions to work together. When every supplying division shares in the margin when a product is sold, it stands to reason that they will be much more anxious to work together to achieve profitable sales, rather than bickering over the transfer prices to be charged internally. Also, any profit improvements that can be brought about only by changes that span several divisions are much more likely to receive general approval and cooperation under this pricing method, since the changes will increase profits for all divisions.
These are powerful arguments, ones which make the contribution margin approach one that is popular as a secondary transfer pricing method, after the market price approach. Despite its useful attributes, there are a number of issues with it that a company must guard against in order to avoid behavior by divisions that will lead to less-than-optimal overall levels of profitability. They are as follows:
- Can increase assigned profits by increasing costs – When the contribution margin is assigned based on a division’s relative proportion of total product costs, it will not take long for the divisions to realize that they will receive a greater share of the profits if they can increase their overall proportion of costs.
- Must share cost reductions – If a division finds a way to reduce its costs, it will only receive an increased share of the resulting profits that is in proportion to its share of the total contribution margin distributed. For example, if division A’s costs are 20 percent of a product’s total costs, and division B’s share is 80 percent, then 80 percent of a $1 cost reduction achieved by division A will be allocated to division B, even though it has done nothing to deserve the increase in margin.
- Requires the involvement of the corporate headquarters staff – The contribution margin allocation must be calculated by somebody, and since the divisions all have a profit motive to skew the allocation in their favor, the only party left that can make the allocation is the headquarters staff. This may require the addition of accountants to the headquarters staff, which will increase corporate overhead.
- Results in arguments – When costs and profits can be skewed by the system, there will inevitably be arguments between the buying and selling divisions that the corporate headquarters team may have to mediate. These issues detract from an organization’s focus on profitability.
The contribution margin approach is not a perfect one, but it does give companies a reasonably understandable and workable method for determining transfer prices. It has more problems than market-based pricing, but can be used as an alternative, or as the primary approach if there is no way to obtain market pricing for transferred products.
In situations where a division cannot derive its transfer prices from the outside market [perhaps because there is no market for its products, or it is a very small one], the cost-plus approach may be a reasonable alternative. This method is based on its name—just accumulate a product’s full cost, add a standard margin percentage to the cost, and this becomes the transfer price. It has the singular advantage of being very easy to understand and calculate, and can convert a cost center into a profit center, which may be useful for evaluating the performance of a division manager.
Unfortunately, the cost-plus approach also has a major flaw, which is that the margin percentage added to a product’s full cost may have no relationship to the margin that would actually be used if the product were to be sold externally. If a number of successive divisions were to add a standard margin to their products, the price paid by the final division in line, the one that must sell the completed product externally, may be so high that there is no room for its own margin, which gives it no incentive to sell the product. Because of this issue, the cost-plus method is not recommended in most situations.
Opportunity Cost Approach
A completely unique approach to the formulation of transfer prices is based on opportunity costs. This method is not precisely based on either market prices or internal costs, since it is founded on the concept of forgone profits. It is best described with an example. If a selling division can earn a profit of $10,000 by selling widget A on the outside market, but is instead told to sell widget B to a buying division of the company, then it has lost the $10,000 that it would have earned on sale of widget A. Its opportunity cost of producing widget B instead of A is therefore $10,000. If the selling division can add the forgone profit of $10,000 onto its variable cost to produce widget B, then it will be indifferent as to which product it sells, since it will earn the same profit on the sale of either product. Thus, transfer pricing based on opportunity cost is essentially the variable cost of the product being sold to another division, plus the opportunity cost of profits forgone in order to create the product being sold.
Under ideal conditions, this method should result in optimum companywide levels of profitability.This concept is most applicable when a division is using all of its available production capacity. Otherwise, it would be capable of producing all products at the same time, and would have no opportunity cost associated with not selling any particular item. To use the same example, if there were no market for widget A, on which there was initially a profit of $10,000, there would no longer be any possible profit, and consequently no reason to add an opportunity cost onto the sale price of widget B. The same principle applies if a company has specialized production equipment that can be used only for the production of a single product. In this case, there are no grounds for adding an opportunity cost onto the price of a product, since there are no other uses for the production equipment.
A problem with the opportunity cost approach is that there must be a substantial external market for sale of the products for which an opportunity cost is being calculated. If not, then there is not really a viable alternative available under which a division can sell its products on the outside market. Thus, though a selling division may point to the current product pricing in a thin external market as an opportunity cost, further investigation may reveal that there is no way that the market can absorb the division’s full production (or can do so only at a much lower price), thereby rendering the opportunity cost invalid.
Another issue is that the opportunity cost is subject to considerable alteration.
Example: The selling division wants to show the highest possible opportunity cost on sale of a specific product, so that it can add this opportunity cost to its other transfer prices. Accordingly, it will skew its costing system by allocating fixed costs elsewhere, showing variable costs based on very high unit production levels and the use of the highest possible prices, to result in a very large profit for that product. This large profit will then be used as the opportunity cost that is forgone when any other products are sold to other divisions, thereby increasing the prices that other divisions must pay the selling division.
This is a technique that is also difficult for the accounting staff to support, because the opportunity cost is not an incurred cost (since it never happened) and therefore does not appear in the general ledger. The level of understandability does not stop with accountants, either. Division managers have a hard time understanding that a transfer price is based on a product’s variable cost plus a margin on a different product that was never produced. Accordingly, gaining companywide support of this concept can be a difficult task to accomplish.