A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. Transfer prices are necessary to calculate costs and revenues in cost, profit, and investment centers. Clearly, the division that is selling the good or service would prefer a high transfer price while the division that is buying would prefer a low transfer price.
1. Do transfer prices matter? From the standpoint of the company as a whole, the transfer price has no effect on aggregate income (other than perhaps from tax effects when divisions are in different states or countries). What is counted as revenue to one division is a cost to the other and is eliminated in the consolidation process. From an economic perspective, it is like taking money out of one pocket and putting it into the other. What does matter is how the transfer price affects the decisions made by the segment managers. In companies in which decentralization is really practiced, segment managers are given a lot of latitude in dealing with each other. Based on the transfer price, a division manager will decide whether to sell a service on the outside market or sell it internally to another division, or whether to buy a part from an outside supplier or internally from another division.
2. Negotiated transfer prices. In principle, if managers understand their own businesses and are cooperative, negotiated transfer prices should work quite well.
a. If a transfer is in the best interests of the entire company, the profits of the entire company should increase. It is always possible in such a situation (barring externalities) to find a transfer price that would increase each participating division’s profits. A pie analogy is helpful to explain this principle. The profits of the entire company are the pie. By cooperating in a transfer, the division managers can make the pie bigger. With a bigger pie, it is always possible to divide it in such a way that everyone gets a bigger piece. And transfer prices provide a means for dividing up the pie.
b. While negotiated transfer prices can work quite well under the right conditions, if managers are uncooperative and highly competitive, negotiations may go nowhere.
3. The lowest acceptable transfer price for the selling division. Clearly, the selling division would like for the transfer price to be as high as possible, but how low would the manager of the selling division be willing to go? The answer is that a manager will not agree to a transfer price that is less than his or her “cost.” But what cost? If the manager is rational and fixed costs are unaffected by the decision, then the manager should realize that any transfer price that covers variable cost plus opportunity cost will result in an increase in segment profits. The opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer. Therefore, the lowest acceptable transfer price as far as the selling division is concerned is:
When there is idle capacity, there are no lost sales and so the total contribution margin of lost sales is zero.
4. Highest transfer price the buying division is willing to pay. In the book and in problems, we generally consider only the situation in which the buying division can buy the transferred item from an outside supplier. In that case, the buying division clearly would not voluntarily agree to a transfer unless:
Transfer price ≤ Cost of buying from outside supplier
5. The range of acceptable negotiated transfer prices. Combining the selling and buying divisions’ perspectives, we can find the range within which a negotiated transfer price will lie. Two situations should be considered.
a. A transfer makes sense from the standpoint of the company if the item can be made inside the company (including opportunity costs) for less that it costs to buy the item from the outside. In algebraic form:
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In this case, any transfer price within the following range will increase the profits of both divisions:
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b. A transfer does not make sense from the standpoint of the company if the item can be purchased from an outside supplier for less than it costs to make inside the company (including opportunity costs). In algebraic form:
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In this case, it is impossible to satisfy both the selling division and the buying division and no transfer will be made voluntarily. And, of course, no transfer should be forced on the managers since a transfer would not be in the best interests of the entire company.
6. Alternative approaches to transfer pricing. If managers understand their own businesses and are cooperative, negotiated transfer prices should work very well. But, if managers do not understand their own businesses or are uncooperative, negotiations are likely to be fruitless. As a consequence, most companies rely on either cost-based or market price-based transfer prices.
a. Cost-based transfer prices. In many companies, transfers are recorded at variable cost, at full cost, or at variable or full cost plus some arbitrary mark-up. These transfer pricing systems are easy to administer, but suffer from serious limitations.
• Cost-based transfer prices can easily lead to bad decisions. If variable costs are used, the transfer price will be too low when there is no idle capacity. If full cost is used, the transfer price will never be correct for decision-making purposes—it will always indicate to the buying division that the cost of the transfer is something other than what it really is to the entire company.
• If there is no profit margin built into the transfer price, then the selling division has no incentive to cooperate in the transfer.
• If the costs of one division are simply passed on to the next division, then there is little incentive for cost control anywhere in the organization. If transfer prices are to be based on cost, then standard cost rather than actual cost should be used.
b. Market-based transfer prices. When there is a competitive outside market for the good or service transferred between the divisions, the market price is often used as a transfer price. This solution is reasonably easy to administer and provides a theoretically correct transfer price when there is no idle capacity. However, when there is idle capacity in the selling division, the transfer price will be too high and the buying division may inappropriately purchase from an outside supplier or cut back on volume.
