Chapter 22: Transfer Pricing

Transfer Pricing refers to the pricing of goods, services, or resources transferred between divisions within the same company. It is a crucial tool in internal transactions, especially in companies structured into various profit, cost, and investment centers. Setting the right transfer price impacts division income, performance evaluations, and ultimately encourages decisions that are beneficial for the company as a whole. Methods to Set Transfer Prices 1. Market-Based Transfer Pricing o Description: Transfer prices are set based on the market price of the goods or services being transferred, reflecting what external customers would pay. o Application:  If the LCD division can sell all touch-screens externally at $80 each, this market price would be a reasonable transfer price. o Advantages:  Encourages divisions to act in the company’s best interest.  Avoids internal conflicts by using a price based on an external benchmark. o Limitations:  May lead to internal conflicts if divisions face differing market pressures or do not agree with external market valuations. 2. Cost-Based Transfer Pricing o Description: Transfer prices are based on the production cost, typically calculated as variable costs or total costs, with the option to add a markup. o Variations:  Variable Cost Pricing: The transfer price covers only the variable cost per unit (e.g., $30 for each LCD screen).  Total Cost Pricing: Includes both variable and fixed costs.  Cost-Plus Pricing: Adds a markup to variable or total cost, providing a margin to the selling division. o Application:  If the LCD division has excess capacity, it could set a transfer price at or above the $30 variable cost. For example, a price of $50 per screen covers variable costs and provides $20 toward fixed costs, making it beneficial to both LCD and the Phone division. o Advantages:  Covers the selling division's costs and is useful when no clear market price exists.  Encourages internal transactions that may not be viable with market pricing. o Limitations: May not reflect true economic value, potentially leading to suboptimal decisions when comparing internal versus external sales. 3. Negotiated Transfer Pricing o Description: Divisions negotiate the transfer price within a range, typically between the variable cost (minimum price for the selling division) and the market price (maximum price for the buying division). o Application:  In the example, the LCD and Phone divisions might negotiate a price between $30 (variable cost) and $80 (market price), arriving at a mutually acceptable price based on their specific circumstances, like a transfer price of $50 if LCD has excess capacity. o Advantages:  Allows flexibility and takes into account the unique conditions of each division.  Encourages collaboration and communication between divisions. o Limitations:  May be affected by power dynamics or negotiation skills, which could lead to suboptimal pricing and conflict.  Time-consuming and may require intervention from top management if divisions cannot agree.  Factors Affecting the Choice of Transfer Price • • • Capacity Utilization: o With excess capacity, cost-based pricing can be effective since it helps cover the variable costs without losing potential market sales. o With no excess capacity, the selling division would prefer a transfer price near the external market price to avoid opportunity costs. Company Objectives: o If maximizing division autonomy and fair evaluations is important, market-based pricing is often preferred. o For situations where collaboration between divisions is crucial, negotiated pricing can provide flexibility. Impact on Performance Evaluation: o Transfer pricing affects the reported profits of each division, influencing managers’ performance evaluations. Poorly set prices can encourage managers to avoid beneficial internal transactions to protect their ROI or residual income figures, leading to suboptimal companywide outcomes. Summary Each transfer pricing method offers benefits and limitations, making the choice dependent on factors such as division autonomy, capacity utilization, and company objectives. By balancing these methods, companies can align internal incentives, foster cooperation between divisions, and promote decisions that benefit the organization as a whole.