CHAPTER6

TRANSFER PRICING

Chapter contents:
6.0 chapter objectives
6.1 introductions
6.2 objectives of transfer prices:
6.3 methods of transfer pricing:
6.3.1 fundamental principle
6.3.2 cost based prices
6.3.3 upstream fixed costs and profits
6.3.4 agreement among business units
6.3.5 two-step pricing
6.3.6 profit sharing
6.3.7 two sets of prices
6.4administration of transfer prices
6.4.1negotiation
6.4.2arbitration and conflict resolution
6.5 summary
6.6 questions

6.0 Chapter objectives:

 To devise a satisfactory method of accounting for the transfer of goods and
services from one profit center to another
 To discuss about various approaches to arriving at transfer prices for transactions
between profit centers
 The system of negotiation and arbitration.
 To discuss about pricing of services that corporate staff units furnish to profit

t
centers.
6.1 INTRODUCTION
oday’s organizational thinking is oriented toward decentralization. one of the
principal challenges in operating a decentralized system is to devise a satisfactory
method of accounting for the transfer of goods and services from one profit center
to another in companies that have a significant amount of these transactions.

in this chapter we discuss various approaches to arriving at transfer prices for transaction
between profit centers and the system of negotiation and arbitration that is essential when
Tran sfer prices are used. We also discuss the pricing of services that corporate staff units
furnish to profit centers.

6.2 objectives of transfer prices

If two or more profit centers are jointly responsible for product development,
manufacturing, and marketing, each should share in the revenue that is generated when
the product is finally sold. The transfer price is not primarily an accounting tool; rather, it
is a behavioral tool that motivates managers to make the right decisions. in particular, the
transfer price should be designed so that it accomplishes the following objectives:

 It should provide each segment with the relevant information required to

determine the optimum trade-off between company costs and revenues.
 It should induce goal congruent decisions-that is, the system should be so
designed that decisions that improve business unit profit will also improve
company profits.
 It should help measure the economic performance of the individual profit centers.
 The system should be simple to understand and easy to administer.

Designing transfer pricing systems is a key management control topic for most
corporations; the govindaRajan survey found that 79 percent of companies transfer
products between profit centers..

6.3 Transfer pricing methods

Some writers use the term “transfer price” to refer to the amount used in accounting for
any transfer of goods and services between responsibility centers. We use a somewhat
narrower definition and limit the term transfer price to the value placed on a transfer or
goods or services in transactions in which at least one of the two parties involve is a
profit center. Such a price normally includes a profit element, because an independent
company would not normally transfer goods or services to another independent company
at cost or less. We, therefore, exclude the mechanics for the allocation of costs in a cost
accounting system; such costs do not include a profit element. The term price, as used
here, has the same meaning as it has when it is used in connection with transactions
between independent companies.

6.3.1Fundamental principle
the fundamental principal is that the transfer price should be similar to the price that would be
charged if the product were sold to outside customers or purchased from outside vendors.

the ideal situation to improve the operation of the transfer price mechanism.
A transfer price will induce goal congruence if all the conditions listed below exist.
Rarely, if ever, will all these conditions exist in practice. The list, therefore, does not ser
for the criteria that must be met to have a transfer price. Rather, it suggests a way of
looking at a situation to see what changes should be made to improve the operation of the
transfer price mechanism.

1.competent people. Ideally, managers should be interested in the long run as well as
the short-run performances of their responsibility centers. Staff people involved in
negotiation and arbitration of transfer prices also must be competent.

2.good atmosphere. Managers must regard profitability as measured in their income

statement as an important goal and as a significant consideration in the judgment of their
performance. they should perceive that the transfer prices are just.

3.a market price. The ideal transfer price is based on a well-established, normal market
price for the identical product being transferred-that is, a market price reflecting the same
conditions (quantity, delivery time, and the like) as the product to which the transfer price
applies. The market price may be adjusted downward to reflect savings accruing to the
selling unit from dealing inside the company. For example, there would be no bad debt
expense and smaller advertising and selling costs when products are transferred from one
business unit to another within the company. Although less than ideal, a market price for
a similar, but not identical, product is better than no market price at all.

4.freedom to source. Alternatives should exist, and managers should be permitted to

choose the alternative that is in their own best interest. The buying manager should be
free to buy from the outside, and the selling manger should be free to sell outside. In
these circumstances, the transfer price policy is simply to give the manager of each profit
center the right to deal with either insider of outsiders, at his or her discretion. The market
thus establishes the transfer price. The decision of whether to deal inside or outside also
is made by the marketplace. If buyers cannot get a satisfactory price from the inside
source, they are free to buy from the outside.
if the selling profit center can sell all of its products, either to insiders or to
outsiders, and as long as the buying center can obtain all of its requirements from either
outsiders or insiders, this method is optimum. The market price represents the
opportunity cost to the seller of selling the product inside. This is so because, if the
product were not sold inside, it would be sold outside. From a company point of view,
therefore, the relevant cost of the product is the market price because that is the amount
of cash that has been forgone by selling inside. The transfer price represents the
opportunity cost to the company.

5.full flow of information. Managers must know about the available alternative and the
relevant costs and revenues of each.

6.negotiation. There must be a smoothly working mechanism for negotiating “contracts”

between business units.
 If all of the above conditions are present, a transfer price system based on market
prices would fulfill all of the objectives stated above, with no need for central
administration. in the next subsection, we consider situations where one or more of these
conditions are not present.

6.3.2cost-based transferprices

if competitive prices are not available, transfer prices may be set up on the basis of cost
plus a profit, even though such transfer prices may be complex to calculate and the results
less satisfactory than a market-based price. Two decisions must be made in a cost-based
transfer price system:
(1) How to define cost?
(2) How to calculate the profit markup?

The cost basis. The usual basis is standard cost. Actual costs should not be used because
production inefficiencies will then be passed on to the buying profit center. If standard
costs are used, there is a need to provide an incentive to set tight standards and to set tight
standards and to improve standards.
Some companies have tried using “efficient producer” costs, but someone has to
decide what this cost are, which is difficult.
Under both cost-plus pricing and market-based pricing, companies typically
eliminate advertising, financing, or other expenses that the seller does not incur on
internal transactions. (This is similar to the practice when two outside companies are
arriving at a price. the buyer ordinarily will not pay for cost components that do not pay
for cost components that do not apply to the contract.)

The profit markup. In calculating the profit markup, there also are two decisions:
(1) On what is the profit markup to be based?
(2) What is the level of profit allowed?

The simplest and most widely used base is a percentage of costs. if this base is used,
however, no account is taken of capital required. A conceptually better base is a
percentage of investment, but there may be a major practical problem in calculating the
investment applicable to a given product. if the historical cost of the fixed assets is used,
new facilities designed to reduce prices could actually increase costs because old assets
are undervalued.
The second problem with the profit allowance is the amount of the profit. Senior
management’s perception of the financial performance of a profit center will be affected
by the profit it shows. Consequently, to the extent possible, the profit allowance should
be the best approximation of the rate of return that would be earned if the business were
an independent company, selling to outside customers. The conceptual solution is to base
the profit allowance on the investment required to meet the volume needed by the buying
profit centers. The investment would be calculated at a “standard” level, with fixed assets
and inventories at current replacement costs. This solution is complicated and, therefore,
rarely used in practice.
 6.3.3Upstream fixed costs and profits

Transfer pricing can create a significant problem in integrated companies. The profit
center that finally sells to the outside customer may not even be aware of the amount of
upstream fixed costs and profit included in its internal purchase price. Even if the final
profit center were aware of these costs and profit, it might be reluctant to reduce its own
profit to optimize company profit. Methods that companies use to mitigate this problem
are described below.

6.3.4 Agreement among business units. A company could establish a formal mechanism
whereby representatives from the buying and selling units meet periodically to decide on
outside selling prices and on the sharing of profits for products having significant
amounts of upstream fixed costs and profit center; otherwise, the value of these
negotiations may not be worth the effort.

6.3.5 Two-step pricing. Another way to handle this problem is to establish a transfer
price that includes two charges. First, a charge is made for each unit sold that is equal to
the standard variable cost of production. Second, a periodic (usually monthly) charge is
made that is equal to the fixed costs associated with the facilities reserved for the buying
unit. One or both of these components should include a profit margin.

Following are some points to consider about the two-step pricing method.

· The monthly charge for fixed costs and profit should be negotiated periodically
and would depend on the capacity reserved for the buying unit.
· Some questions may be raised about the accuracy of the cost and investment
allocation. in some situations, there is no great difficulty in assigning costs and assets to
individual products. In any event, approximate accuracy is adequate. the principal
problem usually is not the allocation technique; rather, it is the decision about how much
capacity is to be reserved for the various products. Moreover, if capacity is reserved for a
group of products sold to the same business unit, there is no need to allocate fixed costs
and investments to individual products in the group.
· Under this pricing system, the manufacturing unit’s profit performance is not
affected by the sales volume of the final unit, which solves the problem that arises when
other business units’ marketing efforts affect the profit performance of a purely
manufacturing unit.
· There could be a conflict be a conflict between the interests of the
manufacturing unit and the interests of the company. if capacity is limited, the
manufacturing unit could increase its profit by using the capacity to produce parts for
outside sale, if it is advantageous to do so. (Stipulating that the marketing unit has first
claim on the capacity it has contracted for mitigates this weakness.)
 · this method is similar to the “take or pay” pricing that is frequently used in
public utilities, pipelines, coal mining companies, and other long-term contracts.

6.3.6Profit sharing. If the two-step pricing system just described is not feasible, a profit
sharing system might be used to ensure congruence of business unit interest with
company interest. this system operates somewhat as follows.

1. The product is transferred to the marketing unit at standard variable cost.

2. After the product is sold, the business units share the contribution earned, which
is the selling price minus the variable manufacturing and marketing costs.

This method of pricing may be appropriate if the demand for the manufactured
product is not steady enough to warrant the permanent assignment of facilities, as in the
two-step method. in general, this method accomplishes the purpose of making the
marketing unit’s interest congruent with the company’s.
There are several practical problems in implementing such a profit sharing
system.

 First, there can be arguments over the way contribution is divided between
the two profit centers. Senior management might have to intervene to
settle these disputes, which is costly, time consuming, and works against a
basic reason for decentralization, namely, autonomy of business unit
managers.
 Second, arbitrarily dividing up the profits between units does not give
valid information on the profitability of each segment of the organization.
 Third, since the contribution is not allocated until after the sale has been
made, the manufacturing unit’s contribution depends on the marketing
unit’s ability to sell and on the actual selling price. Manufacturing units
may perceive this situation to be unfair.

6.3.7 Two sets of prices.

In this method, the manufacturing unit’s revenue is credited at the outside sales price, and
the buying unit is charged the total standard costs. The difference is charged to a
headquarters account and eliminated when the business unit statements are consolidated.
This transfer pricing method is sometimes used when there are frequent conflicts between
the buying and selling units that cannot be resolved by one of the other methods. Both the
buying and selling units benefit under this method.
There are several disadvantages to the system of having two sets of transfer
prices, however. The sum of the business unit profits is greater than overall company
profits. Senior management must be aware of this situation in approving budgets for the
business units and in subsequent EVAluation of performance against these budgets. Also,
this system creates an illusive feeling that business units are making money, while in fact;
the overall company might be losing after taking account of the debits to headquarters.
Further, this system might motivate business units to concentrate more on internal
transfers (where they are assured of a good markup) at the expense of outside sales.
Finally, there is additional bookkeeping involved in first debiting the headquarters
account every time a transfers made and then eliminating this account when business unit
statements are consolidated.
The fact that the conflicts between the business units would be lessened under this
system could be viewed as a weakness. Sometimes, it is better for headquarters to be
aware of the conflicts arising out of transfer prices because such conflicts may signal
problems in either the organizational structure or in other management systems.

Under the two-sets-of –prices method, these conflicts are smoothed over, thereby
not alerting senior management to these problems.

PRACTICE QUESTIONS
Explain the concept of transfer price in brief?
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Explain the objectives of transfer pricing
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Write the fundamental principle of transfer pricing?

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List the methods of transfer pricing available?

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Write a short notes on

 Two step pricing
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 Negotiated pricing
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 Two sets of prices

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6.4 Administration of transfer prices

We have so far discussed how to formulate a sound transfer pricing policy. In this
section, we discuss how the selected policy should be implemented; specifically, the
degree of negotiation allowed in setting the transfer prices, methods of resolving transfer
pricing conflicts, and classification of products according to the appropriate method.

6.4.1 Negotiation
In most companies, business units negotiate transfer prices with each other that is,
transfer prices are not set by a central staff group. Perhaps the most important reason for
this is the belief that one of the primary functions of line management is to establish
selling prices and to arrive at satisfactory purchase prices. If control of pricing is left to
the headquarters staff, line management’s ability to affect profitability is reduced. Also,
many transfer prices require a degree of subjective judgment. Consequently, a negotiated
transfer price often is the result of compromises made by both buyer and seller. if
headquarters establishes transfer prices, business unit managers can argue that their low
profits are due to the arbitrariness of the transfer prices. Another reason for having the
business units negotiate their prices is that they usually have the best information on
markets and costs, and, consequently, are best able to arrive at reasonable prices.

6.4.2Arbitration and conflict resolution

No matter how specific the pricing rules are, there may be instances in which business
units will not be able to agree on a price. For this reason, some procedure should be in
place for arbitration transfer price disputes. There can be widely different degrees of
formality in transfer price arbitration.
 At one extreme, the responsibility for arbitrating disputes is assigned to a single
executive- for example; the financial vice president or the executive vice president- who
talks to business unit managers involved and then announces the price orally.

The other extreme is to set up a committee. Usually such committee will have three
responsibilities:
1. To settle transfer price disputes
2. To review sourcing changes and
3. To change the transfer price rule when appropriate
The degree of formality employed depends on the extent and type of potential transfer
price disputes. in any case, transfer price arbitration should be the responsibility of a
high-level headquarters executive or group, since arbitration decisions can have an
important effect on business unit profits.
Arbitration can be conducted in a number of ways. With a formal system, both
parties submit a written case to the arbitrator. The arbitrator reviews both positions and
decides on the price. In establishing a price, the assistance of other staff offices may be
obtained. For example, the purchasing department might review the validity of a
proposed competitive price quotation, or the industrial engineering department might
review the appropriateness of a disputed standard labor cost. As indicated above, in less
formal systems, the presentations may be largely oral.
It is important that relatively few disputes be submitted to arbitration. If a large
number of disputes are arbitrated, this indicates that the rules are not specific enough, the
rules are difficult to apply, or the business unit organization is illogical. in short, this is a
symptom that something is wrong. Not only is arbitration time consuming to both line
managers and head quarters executives, but also arbitrated prices often satisfy neither the
buyer nor the seller. In some companies, an onus is involved in submitting a price dispute
to arbitration such that very few are ever submitted. if, as a consequence, legitimate
griEVAnces do not surface, the results are undesirable. Preventing disputes from being
submitted to arbitration will tend to hide the fact that there are problems with the transfer
price system.
Irrespective of the degree of formality of the arbitration, the type of conflict
resolution process that is used will also influence the effectiveness of a transfer pricing
system. Lawrence and lurch pointed out four ways to resolve conflicts: forcing,
smoothing, bargaining, and problem solving. The conflict resolution mechanisms range
from conflict avoidance through forcing and smoothing to conflict resolution through
bargaining and problem solving.
PRACTICE QUESTIONS

Explain how the transfer prices will be administered

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How do you price the corporate services?

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6.5 Summary

The delegation of significant amounts of authority is dependent upon the ability to

delegate responsibility for profits. Profit responsibility cannot be safely delegated unless
two conditions exist:

1. The delegate has all of the relEVAnt information to make optimum profit
decisions.
2. The delegatee’s performance is measured on how well he or she has made
cost/revenue trade-offs.
Where segments of a company share responsibility for products development,
manufacturing, and marketing, a transfer price system is required if these segments are to
be delegated profit responsibility. This transfer price system must result in the two
conditions described above. in complex organizations it can be a difficult problem to
devise a transfer price system that assures the necessary knowledge and motivation for
optimum decision-making.
Two decisions are involved in designing a transfer pricing system. First is the
sourcing decision: should the company produce the product inside the company or
purchase it from an outside vendor? Second is the transfer price decision: at which price
should the product be transferred between profit centers?
Ideally, the transfer price should approximate the normal outside market price,
with adjustment for costs not incurred in intracompany transfers. Even under conditions
where sourcing decisions are constrained, the market price is the best transfer price.
If competitive prices are not available, transfer prices may be set on the basis of
cost plus a profit, even though such transfer prices may be complex to calculate and the
results less satisfactory than a market-based price. Cost-based transfer can be made at
standard cost plus profit margin, or by the use of a two-step pricing system.
The method of negotiation transfer prices should be in place, and there should be
an arbitration mechanism for setting transfer price disputes, but these arrangements
should not be so complication that an undue amount of management time is devoted to
transfer pricing.
There are probably few instances in complex organizations where a completely
satisfactory transfer price system exists. As with many management control design
choices, it is necessary to choose the best of perhaps several less than perfect courses of
action. the important thing is to be aware of the areas of imperfections and to be sure that
administrative procedures are employed to avoid sub optimum decisions.

6.6 QUESTIONS
Explain the concept of transfer price in brief?
Explain the objectives of transfer pricing
Write the fundamental principle of transfer pricing?
List the methods of transfer pricing available.
Explain how the transfer prices will be administered
How do you price the corporate services?
Write a short notes on
 Two step pricing
 Negotiated pricing
 Two sets of prices

END