METHODS OF TRANSFER PRICING (4
METHODS)
TRANSFER PRICE
The general rule
specifies the transfer price as the sum of two cost components. The first
component is the outlay cost incurred by the division that produces the goods
or services to be transferred. Outlay costs will include the direct variable
costs of the product or service and any other outlay costs that are incurred
only as a result of the transfer. The second component in the general
transfer-pricing rule is the opportunity cost incurred by the organization as a
whole because of the transfer. An opportunity cost is a benefit that is
forgone as a result of taking a particular action.
Broadly, there are three bases available for
determining transfer prices, but many options are also available within each
base.
These methods are:
(1) Market Prices
(2) Cost-Based Prices
(3) Negotiated Prices
(4) Dual Prices
(1) Market-Based
Prices:
Market price refers to
a price in an intermediate market between independent buyers and sellers. When
there is a competitive external market for the transferred product, market
prices work well as transfer prices. When transferred goods are recorded at
market prices, divisional performance is more likely to represent the real
economic contribution of the division to total company profits. If the goods
cannot be bought from a division within the company, the intermediate product
would have to be purchased at the current market price from the outside market.
Divisional profits are therefore likely to be similar to the profits that would
be calculated if the divisions were separate organizations.
Consequently,
divisional profitability can be compared directly with the profitability
of-similar companies operating in the same type of business. Managers of both
buying and selling divisions are indifferent between trading with each other or
with outsiders. No division can benefit at the expense of another division. In
the market price situation, top management will not be tempted to intervene.
Market-based prices are
based on opportunity costs concepts. The opportunity cost approach signals that
the correct transfer price is the market price. Since the selling division can
sell all that it produces at the market price, transferring internally at a
lower price would make the division worse off.
Similarly the buying
division can always acquire the intermediate goods at the market price, so it
would be unwilling to pay more for an internally transferred goods. Since the
minimum transfer price for the selling division is the market price and the
maximum price for the buying division is also the market price, the only
possible transfer price is the market price.
The market price can be
used to resolve conflicts among the buying and selling divisions. From the
company viewpoint, market price is the optimal so long as the selling division
is operating at full capacity. The market price does not allow any gains or
losses in efficiency of the selling division. It saves administrative costs as
the use of competitive market prices are free from any dispute, argument and
bias.
Further, transfer
prices based on market prices are consistent with the responsibility accounting
concepts of profit centres and investment centres. In addition to encouraging
division managers to focus on divisional profitability, market based transfer
prices help to show the contribution of each division to overall company
profit.
However, there are some
problems using the market price approach:
(i) Appropriate Market
Price may not exist:
Firstly, finding a
competitive market price may be difficult if such a market does not exist.
Catalogue price may only vaguely relate to actual sales prices. Market prices
may change often. Also, internal selling expenses may be less than would be
incurred if the products were sold to outsiders.
Further, the fact that
two responsibility centres are parts of one company indicates that there may be
some advantages from being part of one company and not being two separate
companies dealing with each other in the market. For example, there may be more
certainty about the internal division’s product quality or delivery
reliability. Or the selling division may make a specialized product for which
there are not substitutes in the market. Hence, it may not be possible to use
market prices.
(ii) Excess Production
Capacity:
Another problem with
market prices can occur when a selling division is not operating at full
capacity and cannot sell all its products. To illustrate this point, assume
that material used by Division A in a company is being purchased from outside
market at Rs 200 per unit.
The same materials are
produced by Division B. If Division B is operating at full capacity, say of
50,000 units and can sell all its products to either Division A or to outside
huyers, then the use of transfer price of Rs 200 per unit (market price) has no
effect on Division B’s income or total company profit. Division B will earn
revenue of Rs 200 per unit on all its production and sales, regardless of who
buys its product and Division A will pay Rs 200 per unit, regardless of whether
it purchases the materials from Division B or from an outside supplier. In this
situation, the use of market price as the transfer price is appropriate.
However, if Division B
is not operating at full capacity and unused capacity exists in that division,
the use of market price may not lead to maximisation of total company profit.
To illustrate this point, assume that Division B has unused capacity of 30,000
units and it can continue to sell only 50,000 units to outside buyers.
In this situation, the
transfer price should be set to motivate the manager of Division A to purchase
from Division B if the variable cost per unit of product of Division B is less
than the market price. If the variable costs are less than Rs 200 per unit but the
transfer price is set equal to the market price of Rs 200, then the manager of
Division A is indifferent as to whether materials are purchased from Division B
or from outside suppliers, since the cost per unit to Division B would be the
same, Rs 200.
However, Division A’s
purchase of 20,000 units of materials from outside suppliers at a cost of Rs
200 per unit would not maximise overall company profit, since this market price
per unit is greater than the unit variable cost of Division B, say Rs 100. Hence,
the intra-company transfer could save the company the difference between the
market price per unit and Division B’s unit variable expenses. This savings of
Rs 100 per unit would add Rs 20,00,000 (20,000 units X Rs 100) to overall
company profit.
Transfer prices based
on market prices are consistent with the responsibility accounting concept of
profit centres and investment centres. In addition to encouraging division
managers to focus on divisional profitability, market-based transfer prices
help to show the contribution of each division to overall company profit. When
aggregate divisional profits are determined for the year, and ROI and RI are
computed, the use of a market based transfer price helps to assess the
contributions of each division to overall corporate profits.
Hilton sums up
difficulty associated with general rule of transfer pricing in the following
words:
(i) Difficulting in
Measuring Opportunity Costs:
The general
transfer-pricing rule will always promote goal-congruent decision making if the
rule can be implemented. However, the rule is often difficult or impossible to
implement due to the difficulty of measuring opportunity costs. Such a
cost-measurement problem can arise for a number of reasons. One reason is that
the external market may not be perfectly competitive. Under perfect
competition, the market price does not depend on the quantity sold by anyone
producer.
Under imperfect
competition, a single producer or group of producers can affect the market
price by varying the amount of product available in the market. In such cases,
the external market price depends on the production decisions of the producer.
This in turn means that the opportunity cost incurred by the company as a
result of internal transfers depends on the quantity sold externally. These
interactions may make it impossible to measure accurately the opportunity cost
caused by a product transfer.
(ii) Nature of
Transferred Goods:
Other reasons for
difficulty in measuring the opportunity cost associated with a product transfer
include uniqueness of the transferred goods or services, a need for the
producing division to invest in special equipment in order to produce the
transferred goods, and interdependencies among several transferred products or
services. For example, the producing division may provide design services as
well as production of the goods for a buying division. What is the opportunity
cost associated with each of these related outputs of the producing division?
In many such cases it is difficult to sort out the opportunity costs.
(iii) Distress Market
Prices:
Occasionally an
industry will experience a period of significant excess capacity and extremely
low prices. For example, when gasoline prices soared due to a foreign oil
embargo, the market prices for recreational vehicles and power boats fell
temporarily to very low levels.
Under such extreme
conditions, basing transfer prices on market prices can lead to decisions that
are not in the best interests of the overall company. Basing transfer prices on
artificially low distress market prices could lead the producing division to
sell or close the productive resources devoted to producing the product for
transfer. Under distress market prices, the producing division manager might
prefer to move the division into a more profitable product line.
While such a decision
might improve the division’s profit in the short run, it could be contrary to
the best interests of the company overall. It might be better for the company
as a whole to avoid divesting itself of any productive resources and to ride
out the period of market distress. To encourage an autonomous division manager
to act in this fashion, some companies set the transfer price equal to the
long-run average external market price, rather than the current (possibly
depressed) market price.
(2) Cost Based Prices:
When external markets
do not exist or are not available to the company or when information about
external market prices is not readily available, companies may decide to use
some forms of cost-based transfer pricing system.
Cost-based transfer
prices may be in different forms such as variable cost, actual full cost, full
cost plus profit margin, standard full cost.
(a) Variable Cost:
Variable cost-based
pricing approach is useful when the selling division is operating below
capacity. The manager of the selling division will generally not like this
transfer price because it yields no profit to that division. In this pricing
system, only variable production costs are transferred. These costs are direct
materials, direct labour and variable factory overhead.
Variable cost has the
major advantage of encouraging maximum profits for the entire firm. By passing
only variable costs alone to the next division, production and pricing
decisions are based on cost- volume-profit relationships for the firm as a
whole. The obvious problem is that selling division is left holding all its
fixed costs and operating expenses. That division is now a loss division, no
where near a profit centre.
(b) Actual Full Cost:
In actual full cost
approach, transfer price is based on the total product cost per unit which will
include direct materials, direct labour and factory overhead. When full cost is
used for transfer pricing, the selling division can not realise a profit on the
goods transferred. This may be disincentive to the selling division. Further,
full cost transfer pricing can provide perverse incentives and distort
performance measures. A full cost transfer price would have shutdown the
chances of any negotiation between divisions about selling at transfer prices.
(c) Full Cost Plus
Profit Margin:
Full cost plus mark up
(or profit margin) overcomes the weaknesses of full cost basis transfer pricing
system. The full cost plus price include the allowed cost of the item plus a mark
up or other profit allowance. With such a system, the selling division obtains
a profit contribution on units transferred and hence, benefits if performance
is measured on the basis of divisional operating profits. However, the manager
of the buying division would naturally object that his costs (and hence
reported performance) are adversely affected.
The basic question in
full cost plus mark up is ‘what should be the percentage of mark up.’ It can be
suggested that the mark up percentage should cover operating expenses and
provide a target return on sales or assets.
(d) Standard Costs:
In actual cost
approaches, there is a problem of measuring cost. Actual cost does not provide
any incentive to the selling division to control cost. All product costs are
transferred to the buying division. While transferring actual costs any
variances or inefficiencies in the selling division are passed along to the
buying division.
The problem of
isolating the variances that have been transferred to subsequent buyer division
becomes extremely complex. To promote responsibility in the selling division
and to isolate variances within divisions, standard costs are usually used as a
basis for transfer pricing in cost-based systems.
Whether transferring at
differential costs or full costs, standard costs, where available, are often
used as the basis for the transfer. This encourages efficiency in the selling
division because inefficiencies are not passed onto the buying division.
Otherwise, the selling division can transfer cost inefficiencies to the buying
division. Use of standard cost reduces risk to the buyer. The buyer knows that
standard costs will be transferred and avoids being charged with suppliers’
cost overruns.
(3) Negotiated Prices:
Negotiated prices are
generally preferred as a middle solution between market prices and cost- based
prices. Under negotiated prices, the managers involved act much the same as the
managers of independent companies. Negotiation strategies may be similar to
those employed when trading with outside markets. If both divisions are free to
deal either with each other or in the external market, the negotiated price
will likely be close to the external market price. If all of a selling
division’s output can not be sold in the external market (that is, a portion
must be sold to the buying division), the negotiated price will likely be less
than the market price and the total margin will be shared by the divisions.
The conditions under
which a negotiated transfer price will be successful include:
1. Some Form of Outside
Market for the Intermediate Product:
This avoids a bilateral
monopoly situation in which the final price could vary over too large a range,
depending on the strength and skill of each negotiator.
2. Sharing of all
Market Information Among the Negotiators:
This should enable the
negotiated price to be close to the opportunity cost of one or preferably both
divisions.
3. Freedom to Buy or
Sell Outside:
This provides the
necessary discipline to the bargaining process.
4. Support and
Occasional Involvement of Top Management:
The parties must be
urged to settle most disputes By themselves, otherwise the benefits of
decentralization will be lost. Top management must be available to mediate the
occasional unresolvable dispute or to intervene when it sees that the
bargaining process is clearly leading to suboptimal decisions. But such
involvement must be done with restraint and tact if it is not to undermine the
negotiating process.
Negotiated price avoids
mistrusts, bad feelings and undesirable bargaining interests among divisional
managers. Also, it provides an opportunity to achieve the objectives of goal
congruence, autonomy and accurate performance evaluation. The overall company
is beneficiary if selling and buying divisions can agree upon some mutually
transfer prices. Negotiated transfer price is considered as a vital integrating
tool among divisions of a company which is necessary to achieve goal
congruence.
If negotiations help
ensure goal congruence, top management has little temptation to intervene
between divisions. The agreed prices also can be used for performance
measurement without creating any friction. The use of negotiated prices is
consistent with the concept of decentralised decision-making in the
divisionalised firms.
However, negotiated
prices have the following disadvantages:
(1) A great deal of
management effort, time and resources can be consumed in the negotiating
process.
(2) The final emerging
negotiated price may depend more on the divisional manager’s ability and skill
to negotiate than on the other factors. Thus, performance measures will be
distorted leading to incorrect evaluation of divisional performance.
(3) One divisional
manager having some private information may take advantage of another
divisional manager.
(4) It is
time-consuming for the managers involved.
(5) It leads to
conflicts between divisions.
(6) It may lead to a
suboptimal level of output if the negotiated price is above the opportunity
cost of supplying the transferred goods.
Garrison and Noreen
observe:
“The difficulty is that
not all managers understand their own businesses and not all managers are
cooperative. As a result, negotiations often break down even when it would .be
in the manager’s own best interest to come to an agreement. Sometimes that is
the fault of the way managers are evaluated. If managers are pitted against
each other, rather than against their own past performance or reasonable
bench-marks, a non-cooperative atmosphere is almost guaranteed. Nevertheless,
it must be admitted that even with the best performance evaluation system, some
people by nature are not cooperative.”
(4) Dual Prices:
Under dual prices of
transfer pricing, selling division sells the transferred goods at a (i) market
or negotiated market price or (ii) cost plus some profit margin. But the
transfer price for the buying division is a cost-based amount (preferably the
variable costs of the selling division). The difference in transfer prices for
the two divisions could be accounted for by special centralised account. This
system would preserve cost data for subsequent buyer departments, and would
encourage internal transfers by providing a profit on such transfers for the
selling divisions.
Dual prices give
motivation and incentive to selling divisions as goods are transferred at
market price and this arrangement provides a minimal cost to the buying
division as well. Market price can be considered as the most appropriate base
for the selling division. Thus dual pricing-system has the function of
motivating both the selling division and buying division to make decisions that
are consistent with the overall goals of decentralisation—goal congruence,
accurate performance measurement, autonomy, adequate motivation to divisional manager.
Summary View:
Transfer pricing policy
aims to drive the divisions, who are more inclined to act in their individual
self interest and consider their own costs, prices and market opportunities,
toward behaviour that is best for the organization. Economies of scale,
synergies and saving transaction costs motivate divisional managers to conduct
transactions within the company rather than using market-based transactions
with external supplier and customers.
In reality, no
particular transfer pricing system can be suggested for all decentralised
companies as no one transfer price will be helpful to them in achieving all
their goals and objectives. The divisionalised companies should first determine
their goals and priorities before selecting a transfer pricing.
Therefore, the transfer
pricing methods selected by a particular business enterprise must reflect the
requirements and characteristics of that enterprise and must ultimately be
judged by the decision making behaviour that it motivates. Anderson and
Sollenberger have presented their evaluation of different transfer pricing
approaches as displayed Exhibit 12.1.
Different Transfer
Pricing Approaches
Kaplan and Atkinson
have given the following recommendations in choosing a transfer pricing
practice:
1. Where a competitive
market exists for the intermediate product, the market price, less selling,
distribution, and collection expenses for outside customers, represents an
excellent transfer price.
2. Where an outside
market exists for the intermediate product but is not perfectly competitive and
where a small number of different products are transferred, a
negotiated-transfer- price system will probably work best, since the outside
market price can serve as an approximation of the opportunity cost. At least
occasional transactions with outside suppliers and customers must occur if both
divisions are to have credibility in the negotiating process and if reliable
quotes from external firms are to be obtained.
3. When no external
market exists for the intermediate product, transfers should occur at the
long-run marginal cost of production. This cost will facilitate the decision
making of the purchasing division by providing the stability needed for
long-run planning but at the same time exposing the cost structure so that
short-run improvements and adjustments can be made. A periodic fixed fee based
on capacity reserved for the buying division is incorporated in the marginal
cost calculation.
The fixed fee, ideally
based on product and facility-sustaining costs from an ABC model, should
allocate the capacity-related costs of the facility in proportion to each
user’s planned use of the facility’s resources. The fixed fee forces the
purchasing division to recognize the full cost of the resources required to produce
the intermediate product internally, and it provides a motivation for the
producing divisions to cooperate in choosing the proper level of productive
capacity to acquire.
4. A transfer price
based on fully allocated costs per unit (using present, that is, non-ABC,
methods of allocation) or full cost plus markup has no discernible desirable
properties. Although the full-cost transfer price, has limited economic
validity, it remains widely used. The marginal cost calculated from an ABC
model does provide the capability for managers to use a full-cost approach that
is consistent with economic theory.
