Transfer Pricing: Methods, Objectives and the Optimal Transfer Price

A Lagos furniture group has two divisions. The timber division saws and dries wood, and sells some of it to the furniture division and some to outside carpenters. The furniture division builds cabinets from the timber and sells them to shops. Each division is run as a profit centre and each manager is paid a bonus on divisional profit. At what price should the timber division charge the furniture division?

If the price is too low, the timber manager sells outside and the furniture division has to buy elsewhere. If it is too high, the furniture manager buys from outside suppliers although the group could make more profit by buying in-house. The price that one division charges another within the same company is the transfer price.

It does not change the group’s total profit, but it changes how the profit is shared between divisions and, through the managers’ behaviour, the profit the group actually makes.

This topic explains the purpose and objectives of transfer pricing; transfers at marginal cost, full cost, cost plus and market price; the three-step method for finding the ideal transfer price with no external market, with an external market and no capacity limit, and with a capacity limit; and the other methods used in practice (market price less savings, standard full cost plus, variable cost plus, two-part tariffs, dual pricing and negotiation).

It builds on the earlier topic on economic value added. The next topic covers transfer pricing problems, tax and the repatriation of funds.

Purpose, objectives and the basic methods

What a transfer price is

When a company is divided into divisions, one may supply goods or services to another: the selling division and the buying division. Internal transfers are given a value, the transfer price. For the selling division it is revenue; for the buying division it is cost. The two cancel for the company as a whole, so a company cannot make a profit from internal transfers.

The transfer price could be the cost of the item, or a price above cost, for example cost plus a margin or something related to the external market price. The choice matters because divisional managers are judged and paid on divisional profit or ROI.

Objectives

• Autonomy: divisional managers should be free to decide whether to sell internally or externally, and whether to buy internally or externally, where an external market exists. Autonomy improves motivation.
• Fair performance measurement: the price should allow each division’s profit to be a fair measure of its performance.
• Goal congruence: managers should be led by the transfer price to take decisions that are in the best interests of the company as a whole. Often divisional managers put their division first, especially if they are paid on divisional profit or ROI, and a decision that maximises one division’s profit can reduce another’s and the group’s.

Transfers at cost

Suppose Division A makes 1,000 units of a component at a variable cost of ₦60 and fixed costs of ₦90,000, and transfers them to Division B, which makes a product with further variable costs of ₦40 a unit and fixed costs of ₦70,000, selling 1,000 units at ₦400.

• At marginal (variable) cost, ₦60: A has revenue of ₦60,000 and costs of ₦150,000, a loss of ₦90,000 (equal to its fixed costs). B has revenue ₦400,000, cost ₦60,000 + ₦40,000 + ₦70,000, so a profit of ₦230,000. The group profit is ₦140,000, but B’s profit exceeds the group’s because A’s fixed costs are not in the price.
• At full cost, ₦150.
  (60 + 90): A breaks even (profit nil); B earns ₦400,000 − 150,000 − 40,000 − 70,000 = ₦140,000, equal to the group.
  But B now treats A’s fixed cost as a variable cost, which may distort its pricing and output decisions.
• At cost plus 20%, ₦180:
  A earns ₦180,000 − 150,000 = ₦30,000; B earns 400,000 − 180,000 − 110,000 = ₦110,000; total ₦140,000.
  The profit is shared, but the 20% is arbitrary, and if the price is unrealistic the divisional profits are not satisfactory measures of performance.

Transfers at cost give the selling division little incentive, since it earns little or no profit: in effect it is a cost centre. If the selling division is a profit or investment centre, it should earn a profit on transfers, and the buying division should pay a fair price.

Transfers at market price

When an external market exists for the item, the market price is the most realistic transfer price. A price below it makes the seller want to sell outside; a price above it makes the buyer want to buy outside. It also encourages efficiency in the selling division, which must compete with outside suppliers.

The ideal transfer price, and other methods

Three steps

1. Step 1. Identify the arrangement that maximises the profit (contribution) of the company as a whole.
2. Step 2. Find the transfer price, or range, that will make the buying division want to follow that plan. Its maximum price is the lower of what it would pay externally and the net marginal revenue it earns (selling price of the end product less further variable costs).
3. Step 3. Find the transfer price, or range, that will make the selling division want to follow the plan. Its minimum price is its marginal cost plus the opportunity cost of making the transfer (the contribution lost from not selling externally, or from making another product).

If the maximum exceeds the minimum, any price between them is ideal; if the minimum exceeds the maximum, there is no ideal price. The group is better to buy externally.

Three situations

• No external intermediate market. The transfer price is based on cost. Transfers at cost are suitable only if the selling division is a cost centre; for a profit or investment centre, a negotiated price of cost plus gives it a profit. The ideal range lies between the selling division’s marginal cost (the minimum, if capacity is spare) and the buying division’s net marginal revenue (the maximum).
• An external market and no capacity limit (spare capacity). The selling division can supply internally without losing external sales, so its minimum is its marginal cost. The buying division would not pay more than the external price. The ideal range is from marginal cost to the market price, and the market price is usually used.
• An external market and a capacity limit (no spare capacity). Every unit transferred means a lost external sale, so the minimum is marginal cost plus the contribution lost, which for a single product equals the external price (less any selling costs saved on internal transfers). If the selling division could use its capacity better on another product, the opportunity cost is the contribution of that product, which may raise the minimum above the buyer’s maximum.

Other methods used in practice

• Market price where it exists. It may be reduced to allow for costs the seller saves on internal sales (packaging, warranties, distribution, advertising). It is unsuitable when the market price is only temporary, or when selling more in the market would reduce the price; and it may be hard to find the true market price (rivals differ in quality, availability and service).
• Full cost plus, using standard not actual costs, so that the seller cannot raise profit by inefficiency. Suitable when there is no external market. Disadvantages: the seller’s fixed cost becomes a variable cost for the buyer, leading to decisions against the group’s interest, and the margin is arbitrary.
• Variable (incremental) cost plus, using standard variable cost. Better than full cost plus where there is no external market, since variable cost is nearer to opportunity cost.
• Two-part transfer price: a standard variable cost per unit plus a fixed lump sum each period, which may represent a share of the seller’s fixed costs or of the contribution of the end product; the sum is arbitrary but can be set to give each division a fair profit.
• Dual pricing: where the divisions cannot agree a price at which both want to trade, although trade would raise group profit, the seller is credited at one (higher) price and the buyer charged a lower price; the difference is a head office cost. It is complicated and weakens autonomy.
• Negotiated price: divisional managers agree a price. It can work where no market exists and encourages trade on agreed terms. But the managers may fail to agree (so head office must arbitrate), and the price may reflect bargaining strength and not fairness.

Layouts for the optimal transfer price

1. Group plan: contribution of each alternative (transfer, external sale, buy externally).
2. Buyer’s maximum: net marginal revenue = selling price − further variable costs; compare with external purchase price.
3. Seller’s minimum: marginal cost + opportunity cost (zero if spare capacity).
4. Range and chosen price; contribution of each division and of the company.
5. Comment on fairness and behaviour.

Money is in naira; each answer is rounded once, at the end.

Worked examples

1. Step 1.
   The group earns 400 − 120 − 50 = ₦230 per unit, so it wants as many units as possible to be made.
2. Step 2.
   B’s maximum = 400 − 50 = ₦350.
3. Step 3. A’s minimum = marginal cost ₦120 (spare capacity, no external market).
4. Range ₦120 to ₦350.
   At ₦200, A earns ₦80, B earns 400 − 200 − 50 = ₦150, and the group earns ₦230.
   Fixed cost is ignored because it is the same whichever way the decision goes.

1. Group plan.
   Using the component in B earns 700 − 180 − 210 = ₦310
   selling it externally earns 300 − 180 = ₦120.
   Transfer is better.
2. B’s maximum.
   The lower of the external price ₦300 and net marginal revenue 700 − 210 = 490: ₦300.
3. (a) Spare capacity. A’s minimum = ₦180. Range ₦180 to ₦300; the market price ₦300 is commonly used.
4. (b) No spare capacity.
   A’s minimum = 180 + opportunity cost (300 − 180 = 120) = ₦300.
   The ideal price is ₦300, the market price.

1. B’s maximum. ₦260.
2. A’s minimum.
   170 + lost contribution from Z (300 − 180 = 120) = ₦290.
3. Conclusion. The minimum (₦290) is above the maximum (₦260), so there is no ideal transfer price. The best plan is for B to buy Product Y externally at ₦260 and for A to make and sell Product Z.

Expect variants: a numerical question on the ideal price with a stated capacity limit, a comparison of the profits under marginal cost, full cost and cost-plus prices, a requirement to evaluate each method, and a requirement to describe the other methods.

Sub-optimal decisions and avoidable costs

A transfer price causes a sub-optimal decision when it leads a division to act against the group’s interest. Example. Division A has spare capacity, a variable cost of ₦70 and a full cost of ₦150 a unit, and the external price is ₦110. Division B adds ₦30 and sells the finished product for ₦300.

At a transfer price of ₦150 (full cost) B buys outside at ₦110. The group earns 300 − 110 − 30 = ₦160 a unit instead of 300 − 70 − 30 = ₦200: a loss of ₦40 a unit, because A’s spare capacity is wasted. A price between ₦70 and ₦110 would have led to the right decision.

Avoidable costs. If A would otherwise close down, its fixed costs that would be avoided are an opportunity cost of staying open. Suppose ₦20 of A’s fixed cost a unit is avoidable. A’s minimum price is then 70 + 20 = ₦90; B’s maximum is the lower of the external price ₦110 and its net marginal revenue 300 − 30 = ₦270, so ₦110. The ideal range is ₦90 to ₦110.

If the external price fell below ₦90, the group would be better to close A and buy outside.

What an optimal transfer price is, and pricing for extra volume

An optimal transfer price (or range of prices) for an internally transferred item is one at which:

• (i) the selling division will want to sell to the other division because it adds to its profit
• (ii) the buying division will want to buy because it adds to its profit
• (iii) the transfer is in the best interests of the company as a whole because it maximises total profit

Encouraging extra volume. Suppose the buying division could sell 20,000 more units if it cut its own selling price. Compare, ignoring the transfer price, the extra revenue with the extra variable cost it would bear, then divide by the extra units taken: that is the highest transfer price it can pay and still gain.

Example. Extra sales revenue ₦640,000 less extra variable cost ₦120,000 = ₦520,000 for 2,000 extra tonnes: the transfer price must not exceed ₦260 a tonne. The selling division needs at least its variable cost (say ₦70). Any price between the two persuades both to expand, and group profit rises.

When a negotiated transfer price is used

A negotiated price is used instead of a market price when there is no external market for the item (so no market price exists); when the market is imperfect (differences in quality, quantity discounts, delivery or service make the market price a poor guide); when the item is specialised; when cost savings from trading internally, such as selling and packaging costs, should be shared; and where divisional autonomy is valued and head office wants managers to settle terms.

Its drawbacks are failure to agree and prices that reflect bargaining strength.

Common mistakes

• Forgetting the opportunity cost when the selling division has no spare capacity.
• Including fixed costs in the marginal cost minimum.
• Using the selling price of the end product as the buyer’s maximum instead of net marginal revenue.
• Saying a transfer price changes group profit. It does not, unless it changes decisions.
• Giving one price when a range is asked.
• Not saying when there is no ideal price.

Quick revision

• Group profit unaffected; objectives: autonomy, fair measurement, goal congruence.
• Minimum = marginal cost + opportunity cost. Maximum = net marginal revenue or external price.
• Cost transfers: marginal cost, seller loss; full cost, seller break-even; cost plus, arbitrary.
• Other methods: two-part, dual, negotiated.

How the marks are earned

• Three-step logic with correct figures.
• Range and effect on each division.
• Evaluation of the methods.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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