11.9: Appendix- Transfer Prices between Divisions

Learning Objectives

• Explain how transfer pricing can affect performance evaluation measures.

Question: Many companies have independent divisions that transfer goods or services from one division to another. If division managers are evaluated based only on division results using measures, such as segmented net income, profit margin ratio, or return on investment (ROI), conflicts can arise causing managers to take a course of action that benefits the division but hurts the company as a whole. For example, a division manager may decide to purchase raw materials from an outside supplier even though the same materials can be produced at a lower cost by another division within the company (the other division’s manager refuses to sell the materials at a reduced price because she is evaluated based on her division’s profits!). How should a company establish transfer pricing to avoid this kind of conflict?

Answer

The price used to value the transfer of goods or services between divisions within the same company is called a transfer price. Several different approaches can be used to establish transfer prices between divisions. The goal is to establish a transfer pricing policy that encourages managers to do what is in the best interest of the company while also doing what is in the best interest of the division manager (this is called goal congruence). Several common approaches are presented next.

Using the General Economic Transfer Pricing Rule

Question: How does the general economic transfer pricing rule help organizations to establish an appropriate transfer price?

Answer

The general economic transfer pricing rule attempts to establish guidelines for divisions to maximize overall company profit. This rule states the transfer price should be set at differential cost to the selling division (normally variable cost), plus the opportunity cost of making the sale internally (none if the seller has idle capacity or selling price minus differential cost if the seller is at capacity). This rule is summarized in “Key Equation: Economic Transfer Pricing Rule.”

Key Equation

Economic Transfer Pricing Rule

Let’s look at an example illustrating how to establish a reasonable transfer price using the economic transfer pricing rule. Umbrellas, Inc., has two divisions—Assembly and Marketing. In the past, all transfers of umbrellas from Assembly to Marketing were valued at the variable cost of $6 each. However, the Assembly division manager would like to raise the price to $9 per unit.

Which transfer price should be used to maximize company profit, $6 or $9? The answer depends on whether the selling division (Assembly) is below capacity or at capacity.

Transfer Pricing When Selling Division Is below Capacity

Question: Assume Assembly is below capacity. This means there is no opportunity cost of selling internally since no outside sales are forgone as a result of the transaction. What is the appropriate transfer price in this scenario?

Answer

Given this set of circumstances, the Assembly division should set the transfer price at its variable cost of $6 per unit as shown in “Key Equation: Transfer Pricing When below Capacity (Umbrellas, Inc.).” This ensures Marketing does not purchase the umbrellas from another supplier at an amount greater than Umbrella, Inc.’s variable cost.

Key Equation

Transfer Pricing When below Capacity (Umbrellas, Inc.)

*This is the variable cost for Assembly to produce each umbrella.

**Opportunity cost is zero since no outside sales are forgone as a result of making this internal sale.

If Assembly sets the transfer price higher than $6 per unit ($9 for example), thereby violating the economic transfer pricing rule, the risk is that Marketing might find another company willing to provide the umbrellas for an amount less than $9 and higher than $6. If Marketing chooses to buy umbrellas from an outside supplier for $7, for example, profit declines at Umbrella, Inc., because the company paid $1 more than necessary for each umbrella ($1 = $7 outside supplier price − $6 Umbrella, Inc.’s variable cost). Although Marketing looks better as an investment center buying from the outside for $7 because the cost is $2 less than the internal transfer price, the overall company is worse off because the $7 cost is $1 higher than if the umbrellas were produced internally.

Transfer Pricing When Selling Division Is at Capacity

Question: Now assume Assembly is at capacity. This creates an opportunity cost of selling internally, since outside sales must be forgone as a result of the transaction. What is the appropriate transfer price in this scenario?

Answer

Given this new set of circumstances for Umbrellas, Inc., the Assembly division should set the transfer price at its variable cost of $6 per unit plus the opportunity cost of selling internally. Assume the Assembly division sells the umbrellas to outside customers for $10 each. The opportunity cost of selling internally is $4 (= $10 market price − $6 variable cost). Thus the transfer price that maximizes company profit is $10 as shown in “Key Equation: Transfer Pricing When at Capacity (Umbrellas, Inc.).” Assembly is indifferent whether it sells internally for $10 or to outside customers for $10.

Key Equation

Transfer Pricing When at Capacity (Umbrellas, Inc.)

*This is the variable cost for Assembly to produce each umbrella.

**Opportunity cost is the revenue forgone of $4 by selling internally. Revenue forgone of $4 = $10 market price – $6 variable cost.

The economic transfer pricing rule works well when outside market prices are available (see Note 11.50 "Business in Action 11.5"). However, not all goods or services transferred from one division to another have a readily available outside market price. Thus other methods of establishing transfer pricing must be considered.

Business in Action 11.5

Transfer Pricing at General Electric

A review of the notes to General Electric’s annual report reveals the amount of “intersegment revenues” recorded for each of the company’s six segments. This is referring to revenue derived from transferring goods and services between divisions. The note also states that “sales from one component (segment) to another generally are priced at equivalent commercial selling prices.” It appears from this note that General Electric uses market price to establish transfer prices.

Source: General Electric, “2006 Annual Report,” http://www.ge.com.

Using Cost to Set Transfer Price

Question: Another approach to establishing a transfer price is to use the cost of the goods or services being transferred. How are these costs determined?

Answer

Transfer prices can be based on variable cost, full absorption cost, or cost-plus. Each approach is described next.

Variable Cost

Some companies simply use the selling division’s variable cost as the transfer price. However, the weakness in this approach is the selling division will not be able to mark up its products or services, and as a result, will not be able to generate a profit. This is not a problem for selling divisions treated as cost centers, but profit center and investment center managers will not be satisfied with such an approach.

Full Absorption Cost

Companies sometimes set the transfer price at the selling division’s full absorption cost. The selling division manager prefers to cover all costs rather than only variable costs, and using full-absorption cost accomplishes this goal. However, the company’s concern is the buying division might choose to purchase from an outside provider at a higher price than the differential cost plus opportunity cost but lower than the selling division’s full absorption cost. The result is a decision that does not maximize company profit.

Cost-Plus

Companies often add a markup to the selling division’s variable cost or full absorption cost to set the transfer price. This enables the selling division to earn a profit on internal transfers. Again, the risk is that the buying division might buy from an outside supplier at a higher price than differential cost plus opportunity cost, resulting in lower company profit.

Negotiating Transfer Prices

Question: If the general economic transfer pricing rule is not used, and the cost approach is not used, another alternative is to simply negotiate the transfer price. What are the potential weaknesses in negotiating a transfer price?

Answer

Investment center division managers are often expected to act independent of each other. In fact, many companies treat investment centers as separate businesses. To promote the autonomy of each division manager, companies often require the buying and selling divisions to negotiate a transfer price. This sounds reasonable in concept, but the same weakness exists here as with using costs to set a transfer price. The buying division may choose to purchase the goods or services from an outside supplier if negotiations break down, which may lead to a suboptimal decision for the company as a whole.

An additional weakness is the time required to negotiate a transfer price. Managers can spend significant amounts of time in negotiations when the time might be better spent more productively elsewhere in the division.

Choosing the Best Approach to Establish a Transfer Price

Question: Which transfer pricing approach is best?

Answer

There is no one “best” approach to establishing transfer prices. No two companies are identical, and the choice of a transfer pricing policy depends largely on the nature of the company. The most common approaches used in industry are presented in this appendix. The goal is to establish a transfer pricing policy that encourages managers to do what is in the best interest of the company while also serving the best interest of the division manager.

Key Takeaway

The price used to value the transfer of goods or services between divisions within the same company is called a transfer price. Although there are different approaches for establishing a transfer price, the general economic transfer pricing rule states the transfer price should be set at differential cost to the selling division (normally variable cost) plus the opportunity cost of making the sale internally (none if the seller has idle capacity or selling price minus variable cost if the seller is at capacity). The goal is to establish a transfer pricing policy that encourages managers to do what is in the best interest of the company while also doing what is in the best interest of the division manager.

REVIEW PROBLEM 11.9

Maine Products, LLP, has two divisions—Chocolate and Mint. The Chocolate division typically sells its chocolate to the Mint division for $3 per pound, which covers variable costs. The Chocolate division sells to outside customers for $5 per pound. Use the general economic transfer pricing rule to address the following requirements:

1. Calculate the optimal transfer price assuming the Chocolate division is below capacity.
2. Calculate the optimal transfer price assuming the Chocolate division is at capacity.

Answer

1. Because the Chocolate division is below capacity, no outside customer sales are forgone as a result of selling internally. Thus the opportunity cost of selling internally is zero. The optimal transfer price is $3, calculated as follows:

*This is the variable cost per pound.

**Opportunity cost is zero since no outside sales are forgone as a result of selling internally.

2. Since the Chocolate division is at capacity, outside customer sales are forgone as a result of selling internally. Thus there is an opportunity cost of selling internally. The optimal transfer price is $5, calculated as follows:

*This is the variable cost per pound.

**Opportunity cost is the revenue forgone of $2 by selling internally (= $5 market price − $3 variable cost).