1.

Definition & Objective

2. Effects of Transfer Price
3. Rationale
4. Uses of Transfer Price
5. Alternative Transfer Pricing Schemes
6. International Transfer Pricing
Transfer Price:
- value assigned to goods & services transferred
between co. segments
Fundamental Objective:
- To motivate managers to act in the best
interests of the overall company.
 Affects: - selling divisions sales
- buying divisions costs
Hence, it directly bears on segment margin
No direct effect on cos profit
Transfer price policy: has indirect effect on
co. profit by influencing division mgrs
decisions
 Problem of cos. w/ decentralized segments:
placing a fair value on exchange of
goods/services between co. segments
Formerly (small cos., centralized mgt.): transfer
price = cost of production
Now (giant cos., decentralized org.):
transferring at cost no longer serves needs of
cos.
 Transfer pricing policy can be used to:
1. Discourage outside purchases

2. Motivate division managers

3. Establish & maintain cost control systems

4. Measure internal performance

 Approaches to setting transfer price:
1. Negotiated transfer price

2. Cost-based transfer price

a. Variable cost
b. Full cost
c. Alternative cost measures
3. Market-based transfer price
4. Arbitrary transfer pricing

5. Dual pricing
- Attempts to simulate an arms-length
transaction between supplying & buying
segment
- Result: equivalent of market price
- Advantages:
1. Preserves autonomy of divisional mgr.
2. Mgrs. negotiating transfer price likely to
have better info about transfer costs &
benefits than others in co.
 - Disadvantages:
1. Time-consuming; may require frequent price
re-examination & revision
2. Eliminates objectivity in maximizing co. profits
3. Ability to negotiate may be more of a factor
 Selling divisions lowest acceptable transfer
price:
Transfer price > Variable cost/unit +
Total CM on lost sales
No. of units transferred
OR
Incremental or
differential cost/unit +
Opportunity cost/unit
 Buying divisions highest acceptable transfer
price:
Transfer price < Cost of buying from outside
supplier
or, if an outside supplier doesnt exist:
Transfer price < Profit to be earned per unit
sold (not including the
transfer price)
 1.Variable Cost Transfer Price
2. Full Cost Transfer Price
3. Alternative Cost Measures
a. Full Absorption Cost-Based Transfer Price

b. Cost-Plus Transfer Price

 Variable Cost Transfer Price
-based only on variable or differential costs
- Advantage: ensures best use of total corporate facilities
in short run (focus on CM)
- Disadvantages:
1. Unprofitable in long run: co. must cover all costs
before profiting
2. Receiving segment gets all the profit
3. Could lead to dysfunctional decisions (if selling
segment must forego outside sales)
4. Diminish autonomy of profit centers (dependence of
selling segment on buying segment & its customers)
Full Cost Transfer Price
- Includes actual mfg. costs (variable & fixed)
plus portions of administrative & mktg. costs
- Advantages:

1. Easy & convenient to apply

2. No intra-co. profit to eliminate in
consolidations
3. Simple & adequate end-product costing for
profit analysis
 Full Cost Transfer Price
- Disadvantages:

1. Segments become complacent & less concerned

about cost control
2. No divisional profit figure for selling division

Standard full cost: may be used instead of historical

average cost
- Eliminates negative effect of production
efficiency fluctuations
- Transfer price can be determined in advance
Alternative Cost Measures
a. Full Absorption Cost-Based Transfer Price
- includes only mfg. costs (variable & fixed)
- Advantages:
1. Ready availability of cost data
2. Provides incentive to selling division
to transfer internally (w/ contribution =
excess of full absorption costs over VCs)
b. Cost-Plus Transfer Price
- Based on either VC or full absorption cost

- Apply markup to costs

- Can substitute for market prices when not

available
- Price at w/c goods are sold in the open market;
can be:
- Publicly-listed price of a similar product/service
(e.g., in trade journal)
- External price charged to outside customers by a
subunit
- Designed for situations where theres outside
market for transferred product/service
 If selling division has no idle capacity: market
price is perfect choice for transfer price
Dovetails w/ profit center concept
Makes profit-based performance evaluation feasible
at many org. levels
Particularly useful for highly-decentralized org.
 Relevant guidelines:
1. Buying division must purchase internally so long
as selling division meets all bonafide outside
prices & wants to sell internally.
2. Selling division must be free to reject internal
business if it prefers to sell outside.
3. If selling division doesnt meet all bonafide
outside prices, buying division is free to purchase
outside
4. Independent & impartial body: established to
settle disagreements between divisions
 Market-based transfer prices lead to optimal
decisions when 3 conditions are satisfied:
1. Intermediate market is perfectly competitive
2. Interdependencies of subunits are minimal
3. No additional costs/benefits to corp. as a
whole in using market instead of transacting
internally
 Perfectly competitive market: homogeneous
product w/ equivalent buying & selling prices
& no individual buyers/sellers can affect those
prices by their own actions
3 criteria for optimal transfer-pricing decisions
(to benefit org. as a whole):
1. Goal congruence
2. Management effort
3. Subunit autonomy
 By using market-based transfer prices in
perfectly competitive markets, co. can meet the
3 criteria (goal congruence, etc.).
Distress prices: temporary drop in market prices
well below their historical average (as when
supply outstrips demand)
- some use distress prices
- others use long-run ave. prices, or normal
market prices
 Set by mgt. in corp. headquarters
Premise: overall goals must prevail over
divisions goals
Does not jibe w/ decentralization
 Selling & buying divisions use different
transfer prices
Each divisions performance would improve
Reduces managerial efforts to costs
Rarely used in practice
Transfer Pricing Objectives
- For multinationals:
- Minimize taxes, duties, forex risks
- Enhance companys competitive position
- Improve relations w/ foreign governments
- Domestic cos.:
- Managerial motivation
- Divisional autonomy
Above domestic objectives are secondary for international
transfers.