Transfer pricing objectives and methods

The transfer price directly affects how each division’s performance is measured. If the transfer price is set too low, Division A may appear less profitable even though it is efficient, while Division B will benefit from lower input costs. If the transfer price is set too high, Division B may appear unprofitable despite creating value for the company as a whole.

This illustrates why transfer pricing is important: it ensures that intercompany transactions reflect economic reality, so divisional results are measured fairly and company-wide decisions are made on reliable information.

The objectives of transfer pricing are as follows:

• Accurate performance evaluation: To ensure that the performance of individual units or divisions is evaluated fairly by assigning an appropriate value to the goods or services they exchange.
• Fair cost allocation: To allocate costs appropriately among different units, enabling better transparency and accountability within the organization.
• Tax compliance: To meet regulatory requirements and ensure compliance with tax laws and transfer pricing guidelines in various jurisdictions.
• Financial reporting accuracy: To produce financial reports that accurately reflect the financial performance of each division and the organization as a whole.
• Support strategic decision-making: To enable the organization to make informed decisions regarding resource allocation, pricing strategies, and investment opportunities.

Methods of determining transfer prices

1. Cost-based pricing methods

1.1. Variable cost price

The variable cost method sets the transfer price equal to the variable costs incurred to produce a good or service. This approach ensures that the receiving division is not burdened with fixed costs and reflects the true incremental cost of production.

$$\text{Transfer price}=\text{variable cost per unit}$$

It is simple to calculate, encourages marginal cost decision-making, and ensures transparency in cost control. When using this method, it is generally advisable to base the transfer price on standard variable costs. This approach ensures that any inefficiencies in the production process remain with the supplying division and are not unfairly transferred to the buying division. By isolating inefficiencies, the buying division can better focus on its own operations without being impacted by cost overruns from the supplying division.

Disadvantages:

• Does not cover fixed costs, potentially leading to under-recovery for the supplying division.
• Discourages long-term profitability analysis.
• May lead to disputes if fixed costs are significant for overall operations.

1.2. Full cost price

The full cost method incorporates both variable and fixed costs into the transfer price. This approach ensures that all production costs are covered, making it particularly useful for long-term planning and profitability analysis.

$$\text{Transfer price}=\text{variable cost per unit}+\text{fixed cost allocation per unit}$$

Full cost pricing provides a comprehensive view of production expenses and promotes fairness in cost recovery for the supplying division. As with variable cost, use standard (not actual) full cost so the supplying division’s inefficiencies are not passed to the buyer.

Disadvantages:

• Subjective allocation of fixed costs can cause disputes.
• Higher transfer prices may reduce competitiveness for the receiving division.
• Discourages marginal decision-making.

1.3. Cost-plus price

The cost-plus method adds a predetermined markup to the production cost, which can be based on variable or full costs.

$$\text{Transfer price = cost per unit (variable or full) + markup}$$

This approach encourages profitability for the supplying division while reflecting fair value for internal transactions. Cost-plus pricing is flexible and widely used across different industries to ensure cost recovery and incentivize internal suppliers.

Disadvantages:

• Subjectivity in determining the markup can lead to inconsistencies.
• May inflate transfer prices, reducing the receiving division’s profitability.

2. Market price method

The market price method sets the transfer price based on the price at which the goods or services could be sold externally. If no external demand exists, the price of a similar product in the market can be used.

$$\text{Transfer price = market price (or adjusted market price)}$$

Adjustments can be made for cost savings, such as reduced selling expenses, when transactions occur internally. This method encourages market-based decision-making, reduces internal disputes, and provides a clear benchmark for divisional performance.

Disadvantages:

• Not feasible if no external market or comparable product exists.
• Adjustments to market price may introduce subjectivity.
• High transfer prices can reduce the competitiveness of the receiving division.

3. Negotiated price method

The negotiated price method allows divisions to negotiate a mutually agreed transfer price.

$$\text{Transfer price = agreed price between divisions}$$

This method fosters collaboration and ensures both divisions’ goals are considered, providing flexibility to adapt to unique circumstances. It reflects economic realities and avoids rigid pricing structures, making it suitable for organizations with diverse operational priorities.

Disadvantages:

• Time-consuming and prone to conflicts during negotiations.
• May lead to imbalances if one division has more negotiating power.
• Requires strong managerial oversight to prevent disputes.

4. Dual pricing method

The dual pricing method involves recording different transfer prices for the selling and receiving divisions. For instance, the selling division may record the transfer at the market price, ensuring it recovers its full costs, while the receiving division records it at variable cost, reflecting cost savings from internal transactions.

$$\text{Selling division price = market price}$$

$$\text{Receiving division price = variable cost price}$$

This method reduces internal disputes and promotes divisional harmony. However, because the seller records more revenue than the buyer records as cost, the sum of divisional profits exceeds companywide profit, so the difference must be eliminated at headquarters. It’s important to note that the policies governing this approach are determined by the organization. The dual-pricing method simply involves using two different prices for the same transaction: one for the selling division and another for the buying division.

Disadvantages:

• It can be more complex to implement and reconcile.
• Raises potential tax compliance issues, especially in multinational operations.
• The selling division has less incentive to control costs, since it recovers its price regardless of efficiency.

Example: Calculating transfer prices

Division A produces a component with a variable cost of $40 per unit and a fixed cost allocation of $15 per unit. Division A can sell the component externally at a market price of $80 per unit, but selling to Division B internally saves $5 per unit in selling costs. Division A’s cost-plus policy applies a 20% markup to full cost.

• Variable cost price: $40
• Full cost price: $40 + $15 = $55
• Cost-plus price: $55 × 1.20 = $66
• Adjusted market price: $80 − $5 = $75
• Dual pricing: the selling division records $75 (market price) and the receiving division records $40 (variable cost)
• Negotiated price: any price the two divisions agree on, typically between $40 (the selling division’s floor: its variable cost, when it has idle capacity) and $80 (the buying division’s ceiling: the market price it would pay an outside supplier)

Answer: Variable cost = $40; full cost = $55; cost-plus = $66; adjusted market = $75; dual pricing = $75 (seller) / $40 (buyer); negotiated price falls between $40 and $80.

Business considerations such as the presence of outside suppliers, idle versus full capacity, and special multinational issues like tariffs, exchange rates, taxes, currency restrictions, and expropriation risk also shape transfer pricing decisions - we cover these in the next chapter, Transfer pricing and business issues.