Transfer Pricing MethodsTo determine whether each division is achieving its organizational objectives, managers must be accountable for the goods and services they acquire, both externally and internally. When goods or services are exchanged internally between segments of a decentralized organization, the way that the transferor and the transferee will report the transfer must be determined, either by negotiations between the two segments or by corporate policy. A transfer price is the internal value assigned a product or service that one division provides to another. The transfer price is recognized as revenue by the division providing goods or services and as expense (or cost) by the division receiving them. Transfer-pricing transactions normally occur between profit or investment centers rather than between cost centers of an organization; however, managers often consider cost allocations between cost centers as a type of transfer price.

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The post discusses on the challenges of establishing transfer prices that motivate managers to make decisions that are beneficial to their divisions as well as the overall company. However, recent research, discussed later, concluded that there are often price benefits when dealing with outside vendors, if the company has the option of acquiring the goods or services internally. Follow on…

 

 

Management Consideration

The desire of the selling and buying divisions of the same company to maximize their individual performance measures often creates transfer-pricing problems. Acting as independent units, divisions could take actions that are not in the best interest(s) of the organization as a whole. The three examples that follow illustrate the need for organizations to maintain a corporate profit-maximizing viewpoint while attempting to allow divisional autonomy and responsibility.

 

Case Example

PutraTech, Inc., has five divisions, some of which transfer products and product components to other PutraTech divisions. The DharmaTech Division manufactures two products, Alpha and Beta. It sells Alpha externally for $50 per unit and transfers Beta to the LieTech Division for $60 per unit. The costs associated with the two products follow:

                                                                Product
                                                            Alpha      Beta
Variable costs
     Direct materials                               $15         $14
     Direct labor                                         5           10
     Variable manufacturing overhead       5           16
     Selling                                                 4             0
Fixed Costs
     Fixed manufacturing overhead           6            15
Total                                                     $35         $55

 

An external company has just proposed to supply a Beta substitute product to the LieTech Division at a price of $52. From the company’s viewpoint, this is merely a “make or buy” decision. The relevant costs are the differential outlay costs of the alternative actions. Assuming that the fixed manufacturing costs of the DharmaTech Division are unavoidable, the relevant costs of this proposal from the company’s perspective are as follows:

Buy                                                              $52
Make
  Direct materials                                  $14
  Direct labor                                          10
  Variable manufacturing overhead         16
                                                                    (40)
Difference                                                   $12

 

From the corporate viewpoint, the best decision is for the product to be transferred since the relevant cost is $40 rather than to buy it from an external source for $52.

 

 

The decision for the LieTech Division management is basically one of cost minimization: Buy from the source that charges the lowest price

If DharmaTech is not willing to transfer Beta at a price of $52 or less, the LieTech management could go to the external supplier to maximize the division’s profits. (Although LieTech’s managers are concerned about the cost of Beta, they are also concerned about the quality of the goods. If the $52 product does not meet its quality standards, LieTech could decide to buy from DharmaTech at the higher price. For this discussion, assume that the internal and external products are identical; therefore, acting in its best interest, LieTech purchases Beta for $52 from the external source unless DharmaTech can match the price).

Prior to LieTech’s receipt of the external offer, DharmaTech had been transferring Beta to LieTech for $60. DharmaTech must decide whether to reduce the contribution margin on its transfers of Beta to LieTech and, therefore, lower divisional profits or to try to find an alternative use for its resources. Of course, corporate management could intervene and require the internal transfer even though it would hurt DharmaTech’s profits.

As the second example, assume that the DharmaTech Division has the option to sell an equivalent amount of Beta externally for $60 per unit if the LieTech Division discontinues its transfers from DharmaTech.

Now the decision for DharmaTech’s management is simple: Sell to the buyer willing to pay the most.

From the corporate viewpoint, it is best for DharmaTech to sell to the external buyer for $60 and for LieTech to purchase from the external provider for $52.

 

To examine a slightly different transfer-pricing conflict, assume that the DharmaTech Division can sell all the Alpha that it can produce (it is operating at capacity). Also assume that there is no external market for Beta, but there is a one-to-one trade-off between the production of Alpha and Beta, which use equal amounts of the DharmaTech Division’s limited capacity.

The corporation still regards this as a make or buy decision, but the costs of producing Beta have changed. The cost of Beta now includes an outlay cost and an opportunity cost. The outlay cost of Beta is its variable cost of $40 ($14 + $10 + $16), as previously computed. Beta’s opportunity cost is the net benefit foregone if the DharmaTech Division’s limited capacity is used to produce Beta rather than Alpha:

Selling price of Alpha                                $50
Outlay costs of Alpha
  Direct materials                              $15
  Direct labor                                        5
  Variable manufacturing overhead      5
  Variable selling                                  4
                                                                  (29)
Opportunity cost of making Beta              $21

 

Accordingly, the relevant costs in the make or buy decision follow:

Make Outlay cost of Beta    $40
Opportunity cost of Beta       21
                                                   $61
Buy                                             $52

 

From the corporate viewpoint, LieTech should purchase Beta from the outside supplier for $52 because in this case it costs $61 to make the product. If there were no outside suppliers, the corporation’s relevant cost of manufacturing Beta would be $61. This is another way of saying that the LieTech Division should not acquire Beta internally unless its revenues cover all outlay costs (including the $40 in the DharmaTech Division) and provide a contribution of at least $21 (=$61 -$40).

From the corporate viewpoint, the relevant costs in make or buy decisions are the external price, the outlay costs to manufacture, and the opportunity cost to manufacture. The opportunity cost is zero if there is excess capacity.

 

 

Transfer Pricing and External Competition

Researchers found that a firm can glean benefits from discussing transfer-pricing problems with external suppliers. Though transfer prices above marginal cost introduce interdivision coordination problems, they also reduce a firm’s willingness to pay outside suppliers. Knowing that costly internal transfers will eat into demand, the supplier is more willing to set lower prices. Such supplier discounts can make decentralization worthwhile for the firm. The benefit of decentralization is shown to be robust in both downstream and upstream competition. [Source: Anil Arya and Brian Mittendorf, “Interacting Supply Chain Distortions: The Pricing of Internal Transfers and External Procurement,” The Accounting Review, May 2007.]

 

 
Determining Transfer Price Methods

As illustrated, the transfer price of goods or services can be subject to much controversy. The most widely used and discussed transfer prices are covered in this section. Although a price must be agreed upon for each item or service transferred between divisions, the selection of the pricing method depends on many factors. The conditions surrounding the transfer determine which of the alternative methods discussed subsequently is selected.

Although no method is likely to be ideal, one must be selected if the profit or investment center concept is used. In considering each method, observe that each transfer results in a revenue entry on the supplier’s books and a cost entry on the receiver’s books. Transfers can be considered as sales by the supplier and as purchases by the receiver.

 

1. Market Price Method – When there is an existing market with established prices for an intermediate product and the transfer actions of the company will not affect prices, market prices are ideal transfer prices. If divisions are free to buy and sell outside the firm, the use of market prices preserves divisional autonomy and leads divisions to act in a manner that maximizes corporate goal congruence. Unfortunately, not all product transfers have equivalent external markets. Furthermore, the divisions should carefully evaluate whether the market price is competitive or controlled by one or two large companies. When substantial selling expenses are associated with outside sales, many firms specify the transfer price as market price less selling expenses. The internal sale may not require the incurrence of costs to get and fill the order.

Case Example:

To illustrate using the PutraTech example, assume that product Alpha of the DharmaTech Division can be sold competitively at $50 per unit or transferred to a third division, the Quantum Division, for additional processing. Under most situations, the DharmaTech Division will never sell Alpha for less than $50, and the Quantum Division will likewise never pay more than $50 for it. However, if any variable expenses related to marketing and shipping can be eliminated by divisional transfers, these costs are generally subtracted from the competitive market price. In our illustration in which variable selling expenses are $4 for Alpha, the transfer price could be reduced to $46 ($50 -$4). A price between $46 and $50 would probably be better than either extreme price. To the extent that these transfer prices represent a nearly competitive situation, the profitability of each division can then be fairly evaluated.

 

2. Equal To Variable Costs Method – If excess capacity exists in the supplying division, establishing a transfer price equal to variable costs leads the purchasing division to act in a manner that is optimal from the corporation’s viewpoint. The buying division has the corporation’s variable cost as its own variable cost as it enters the external market. Unfortunately, establishing the transfer price at variable cost causes the supplying division to report zero profits or a loss equal to any fixed costs. If excess capacity does not exist, establishing a transfer price at variable cost would not lead to optimal action because the supplying division would have to forego external sales that include a markup for fixed costs and profits.

Case Example

If Beta could be sold externally for $60, the DharmaTech Division would not want to transfer Beta to the LieTech Division for a $40 transfer price based on the following variable costs:

Direct materials                               $14
Direct labor                                        10
Variable manufacturing overhead      16
Total variable costs                        $ 40

The DharmaTech Division would much rather sell outside the company for $60, which covers variable costs and provides a profit contribution margin of $20:

Selling price of Beta      $60
Variable costs               (40)
Contribution margin     $20

 

3. Variable Plus Opportunity Costs Method – From the organization’s viewpoint, variable plus opportunity cost is the optimal transfer price. Because all relevant costs are included in the transfer price, the purchasing division is led to act in a manner optimal for the overall company, whether or not excess capacity exists. With excess capacity in the supplying division, the transfer price is the variable cost per unit. Without excess capacity, the transfer price is the sum of the variable and opportunity costs.

Case Example:

Following this rule in the previous example, if the DharmaTech Division had excess capacity, the transfer price of Beta would be set at Beta’s variable costs of $40 per unit. At this transfer price, the LieTech Division would buy Beta internally, rather than externally at $52 per unit. If the DharmaTech Division cannot sell Beta externally but can sell all the Alpha it can produce and is operating at capacity, the transfer price per unit would be set at $61, the sum of Beta’s variable and opportunity costs ($40 + $21). (Refer back two pages.) At this transfer price, the LieTech Division would buy Beta externally for $52. In both situations, the management of the LieTech Division has acted in accordance with the organization’s profit-maximizing goal.

 

Note:

There are two problems with this method:

  • First, when the supplying division has excess capacity, establishing the transfer price at variable cost causes the supplying division to report zero profits or a loss equal to any fixed costs.
  • Second, determining opportunity costs when the supplying division produces several products is difficult. If the problems with the previously mentioned transfer-pricing methods are too great, three other methods can be used: absorption cost plus markup, negotiated prices, and dual prices.

 

4. Absorption Cost Plus Markup Method – According to absorption costing, all variable and fixed manufacturing costs are product costs. Pricing internal transfers at absorption cost eliminates the supplying division’s reported loss on each product that can occur using a variable cost transfer price. Absorption cost plus markup provides the supplying division a contribution toward unallocated costs. In “cost-plus” transfer pricing, “cost” should be defined as standard cost rather than as actual cost. This prevents the supplying division from passing on the cost of inefficient operations to other divisions, and it allows the buying division to know its cost in advance of purchase. Even though cost-plus transfer prices may not maximize company profits, they are widely used. Their popularity stems from several factors, including ease of implementation, justifiability, and perceived fairness. Once everyone agrees on absorption cost plus markup pricing rules, internal disputes are minimized.

 

5. Negotiated Prices Method – Negotiated transfer prices are used when the supplying and buying divisions independently agree on a price. As with market-based transfer prices, negotiated transfer prices are believed to preserve divisional autonomy. Negotiated transfer prices can lead to some suboptimal decisions, but this is regarded as a small price to pay for other benefits of decentralization. When they use negotiated transfer prices, some corporations establish arbitration procedures to help settle disputes between divisions. However, the existence of an arbitrator with any real or perceived authority reduces divisional autonomy. Negotiated prices should have market prices as their ceiling and variable costs as their floor. Although frequently used when an external market for the product or component exists, the most common use of negotiated prices occurs when no identical-product external market exists. Negotiations could start with a floor price plus add-ons such as overhead and profit markups or with a ceiling price less adjustments for selling and administrative expenses and allowances for quantity discounts. When no identical-product external market exists, the market price for a similar completed product can be used, less the estimated cost of completing the product from the transfer stage to the completed stage.

 

6. Dual Prices Method – Dual prices exist when a company allows a difference in the supplier’s and receiver’s transfer prices for the same product. This method allegedly minimizes internal squabbles of division managers and problems of conflicting divisional and corporate goals. The supplier’s transfer price normally approximates market price, which allows the selling division to show a “normal” profit on items that it transfers internally. The receiver’s price is usually the internal cost of the product or service, calculated as variable cost plus opportunity cost. This ensures that the buying division will make an internal transfer when it is in the best interest of the company to do so.

 

Conclusions

In most cases, a market-based transfer price achieves the optimal outcome for both the divisions and the company as a whole. As discussed earlier, an exception occurs when a division is operating below full capacity and has no alternative use for its excess capacity. In this case, it is best for the company to have an internal transfer; therefore, to ensure that the receiving division makes an internal transfer, the company must require the internal transfer as long as its price does not exceed the established market rate.

The only time an external price is more attractive when excess capacity exists is when the external price is below the variable cost of the providing internal division, and that scenario is highly unlikely.

A potential transfer-pricing problem exists when divisions exchange goods or services for which no established market exists. For example: suppose that a company is operating its information technology (IT) service department as a profit center that transfers services to other profit center departments using a cost-plus transfer price. If the departments using IT services can choose to use those services or to replicate them inside their departments, users might not make a decision that is best for the company. It could be best for the company to have all IT services come from the IT department, but other profit centers could believe that they can provide those services for themselves at lower cost. In this case, the company must decide how important it is to maintain the independence of its profit center. In the interest of maintaining a strong profit center philosophy, top management can decide that it is acceptable to sub-optimize by allowing profit centers to provide IT services for themselves.

The ideal transfer-pricing arrangement is seldom the same for both the providing and receiving divisions for every situation. In these cases, what is good for one division is likely not to be good for the other division resulting in no transfer, even though a transfer could achieve corporate goals. These conflicts are sometimes overcome by having a higher-ranking manager impose a transfer price and insist that a transfer be made. Managers in organizations that have a policy of decentralization, however, often regard these orders as undermining their autonomy. Therefore, the imposition of a price could solve the corporate profit optimization problem but create other problems regarding the company’s organization strategy. Transfer pricing thus becomes a problem with no ideal solutions.