CHAPTER 8

Transfer Pricing
1 Principles of transfer pricing
What is a transfer price?
A transfer price is the price at which goods or services are transferred from one profit centre to another within the same organisation..

Objectives of a transfer pricing system

Goal congruence The decisions made by each profit centre manager should be consistent with the objectives of the organisation as a whole. Performance appraisal The performance of each responsibility centre should be capable of being assessed. Divisional autonomy The system used to set transfer prices should seek to maintain the autonomy of profit centre managers

Transfer pricing with no external market

The receiving division may be selling on a perfect market or an imperfect market. A perfect market is one where the receiving division must accept this market price (because there are many companies in the field and no one company can dictate to the market).

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An imperfect market is one where the receiving division sets the market price for the final product (perhaps because there is a monopoly).

Example
A firm manufactures and sells shepherds crooks. The company is organised into two divisions, one of which concentrates on manufacturing the basic crook, while the other finishes the crook and is responsible for selling and distribution. The total annual cost and demand functions are as shown below. Total annual cost in manufacturing division, CM = 5,000 + 4Q + 0.0001Q2 Total annual cost in selling division, CS = 10,000 + 8Q + 0.00005Q2 Selling price, PS = 24 0.00048Q All cost and price figures are in pounds and Q denotes annual production and sales. CS excludes any costs transferred from the manufacturing division. Required Calculate the optimal transfer price to maximise overall profitability.

Solution
Profit is maximised when marginal cost and marginal revenue are equal. Looking at the company overall, the optimal activity level can be found by equating expressions for marginal revenue and the combined marginal cost of each division. Notice that the marginal revenue and marginal cost are obtained by differentiating the revenue and cost functions.

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Chapter 8 Transfer Pricing

Selling price Revenue Marginal revenue Companys total cost PS RS MRS CC = 24 0.00048Q = PS x Q = 24Q 0.00048Q2 =

dR = 24 0.00096Q dQ

= CM + CS = 15,000 + 12Q + 0.00015Q2

Companys marginal cost

MCC =

d (Cc ) dQ

= 12 + 0.0003Q

Profit is maximised when marginal cost equals marginal revenue, ie when: 24 0.00096Q 0.00126Q Q PS = 12 + 0.0003Q = 12 = 9,524 = 24 0.00048Q = 19.43 The company should manufacture 9,524 crooks a year and sell them at 19.43 each. We now use this to establish a transfer price. Any transfer price that is fixed represents marginal revenue to the manufacturing division and additional marginal costs to the selling division. The price must be set to ensure that each divisions profit is maximised at an activity level of 9,524 crooks a year.

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The marginal cost in the manufacturing division at a level of 9,524 is found as follows. MCM =

d( C M ) dQ

4 + 0.0002Q

When Q is 9,524,

MCM = 4 + 0.0002 x 9,524 = 5.9048

This, therefore, should be the transfer price: 5.90 The marginal cost in the selling division, excluding the transfer price, is given by: MCS = 8 + 0.0001Q Including the transfer price, this becomes: Marginal costs = 13.905 + 0.0001Q It will be seen that by comparing this with the selling divisions marginal revenue, MR = 24 0.00096Q the selling divisions profit is maximised when: 13.905 + 0.0001Q Q= = = 24 0.00096Q 9,524

10.095 0.00106

Thus, using a transfer price of 5.90 per crook, each divisions profit is maximised at an activity level of 9,524, which is also the optimal activity level for the company overall.

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Transfer pricing with an external market

A perfect market for the intermediate product

The situation we are now considering is illustrated below.

External market

Perfect market for intermediate product Imperfect market for final product
Receiving Division

Supplying Division

Intermediate product

To show the effects of this new situation we extend our previous example by supposing that a perfect market exists for unfinished crooks. The transfer price will be the same as the market price. If a transfer price were set above this figure, the second (finishing and selling) division would not wish to buy from the manufacturing division but would prefer to buy from outside. If a transfer price was set below market price, the first (manufacturing) division would not wish to transfer to the selling division but would prefer to sell outside.

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ACCA PAPER F5- FOCUS NOTES An imperfect market for the intermediate product
This situation is illustrated below. An imperfect market for the intermediate product

External market

Imperfect market for intermediate product Imperfect market for final product
Receiving Division

Supplying Division

Intermediate product

The manufacturing division is now faced with a decision as to which of two markets the unfinished crooks should be sold in. Suppose unfinished crooks could be sold in a market where the following demand curve applied: Selling price, unfinished crooks, PM = 12 0.0002Q It is in the companys best interests for the manufacturing division either to sell crooks in the intermediate market or to pass them on to the selling division according to where marginal revenue (in the case of the selling division, net marginal revenue) is the greater. MCM = 4 + 0.0002Q MRM = 12 0.0004Q NMRS = 16 0.00106Q 92

Chapter 8 Transfer Pricing

Initially the manufacturing division should pass crooks on to the selling division, but eventually the net marginal revenue from the selling division will fall to 12 (the same as marginal revenue initially in the intermediate market), at a sales level of 3,774. From then on the manufacturing division should also sell outside. Suppose that the manufacturing division produces D units for sale on the intermediate market and E units to the selling division for conversion into finished crooks. Profit will be maximised when: MCM = MRM = NMRS 4 + 0.0002 (D + E) = 12 0.0004D = 16 0.00106E Equating the first two and the second two: 4 + 0.0002D + 0.0002E 0.0004D 12 0.0004D Rearranging: 2E + 6D 10.6E 4D Solving simultaneously: D E C=D+E = = = 10,726 7,821 18,547 = = 80,000 (1) 40,000 (2) = 16 0.00106E = 12

The optimal transfer price can be found by substituting C, D or E into the appropriate marginal cost or revenue expression. Using the expression for marginal cost:

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Optimal transfer price = = 4 + (0.0002 x 18,547) 7.71

Transfer pricing in practice

Transfer prices based on market prices

The market price used for an internal transfer price should be that charged by the supplier who most accurately reflects the product quality, delivery and other auxiliary terms and services offered by the internal producer. It will often happen that a slightly lower price than market price may be used for internal transfer purposes, to take account of the lower transaction costs involved.

Outside purchases
Divisional independence involves the freedom for a buying division to make use of outside sources of supply. This might occur, for example, when owing to market imperfections, an outside suppliers price is below that of the internal supplying division. If the supplying division had unutilised capacity, it would normally be preferable to make use of that capacity rather than to purchase from outside. Divisional autonomy might therefore be overridden by a central directive that purchases will be made internally whenever the capacity exists.

Transfer prices based on costs

It may happen that there is no open market price for the intermediate product.

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Actual or standard costs?

Chapter 8 Transfer Pricing

Unless the intermediate product is a one-off customised order, it is best to use the long-run standard cost as a basis for transfer pricing.

Full or variable costs?

To provide incentive to the supplying division, the transfer price system would need to give some contribution towards fixed costs and profit. However, if this is done by setting the transfer price on a full cost plus basis, it may lead to suboptimal decisions being taken.

Illustration
Division B sells a final product to outside customers at 14 per unit. It buys an intermediate product from Division A at 4 per unit and incurs additional variable processing costs of 10.50 per unit. The transfer price of 4 from Division A comprises: Per unit Variable costs Fixed costs, absorbed on the basis of budgeted activity Profit Transfer price 1.50 1.20 1.30 ____ 4.00 ====

Division B thus loses 0.50 on every unit of final product, and will be motivated either to discontinue the product or to seek an outside alternative supplier to replace Division A.

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If we look more closely at the figures we find that it is in fact the best course for the company as a whole for B to continue purchasing from A and selling the final product. For the company as a whole, each outside sale yields contribution as follows. Final selling price Variable costs Division A Division B 1.50 10.50 _____ 12.00 _____ Contribution towards the companys fixed costs and profit 2.00 ===== 14.00

Here, a transfer price has been set which has sent the wrong signals to the manager of Division B, leading him to act in a way which, although it appears optimal for his own division, is not optimal for the company as a whole.

Transfer prices based on opportunity cost

An often-quoted method of setting transfer prices is that they should be based on marginal cost of producing the item transferred plus opportunity cost to the company of making the transfer.

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