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Transfer pricing
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Role of transfer pro king, key issues, numerical example and explanation of the various methods. Many examples and images.
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Managerial accounting 2.11.20Transfer pricing
Transfer pricing
o The pricing charged by one division selling goods or services to another division within
the same company
o In larger corporations
o The price charged between segments is the transfer price
o Division A (seller) provides components to Division B (buyer) for their product
- Internally bought
- Price payed is the transfer price between the divisions
o A result of decentralisation and delegation
o Transfer pricing systems account for any internal transactions
o The system must give the correct incentive and increase the value of the company as a
whole
o Decentralisation:
- Creates the need for interaction between subunits
- Subunits have to decide whether to buy the goods or services externally or internally
o Setting transfer prices affects the profit measure for both the selling divisions and buying
division
- A higher transfer price means greater profits for the selling division
- Should provide each business unit with the relevant information it needs to determine
the optimum trade-off between company cost and revenue (internal or external
purchase)
- It should induce goal congruent decisions
- It should help measure the economic performance of the individual business units
- The system should be simple to understand and easy to administer
Key issues and impact of transfer prices
o Refers to internal transactions only
o Subunits can be profit or investment centres (objective to maximise profit and IC
maximising profit whilst considering capital invested into account)
o The transfer price affects the income of the buying and selling units within the company
and will therefore affect profitability
o Could be argued that: No impact on overall company profit but can have an impact if
significance depends on the number of transactions – all internal so no effect
- No loss as all internal
o But transfer price set can affect decisions of managers so can affect overall profitability of
the company
, Managerial accounting 2.11.20
- If price set high, the buyer may choose to buy externally instead
o Must ensure the manager’s goals are consistent with the organisational goals – goal
congruency
Transfer pricing rule
o Goal congruency is achieved by following a general transfer pricing rule:
- Transfer price = additional unit outlay cost incurred because goods are transferred
internally (variable cost of production) + opportunity cost per unit to the organisation
because of the transfer (profit margin)
- I.E: V cost of production + profit margin
o Selling division is reimbursed
o If the external market is willing to buy all goods/services, what is the opportunity cost of
selling to an internal division?
o Must make decision which maximises profitability of organisation as a whole
o What would the transfer price be if there was no external buyer?
o How feasible is this general model to implement in practise?
- Difficult to implement
- Difficulty to quantify the opportunity cost
- Problems in measuring a transfer’s opportunity cost
- Many sellers in a market with unique goods and services (no benchmark as products
are unique)
Transfer pricing example
o No excess capacity (sell everything produced to external market)
o A battery division makes a standard 12-volt battery (Selling division)
o The battery division is currently selling 300,000 batteries to outsiders (external market) at
£40
o The auto division can use 100,000 of these in the X-7 models
o VC = £18 per battery
40-18=22
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