Cost Category Cost driver Details Of Cost Driver Quantities Total Quantity of Cost Driver

1 2 3 4 (5)=(3)x(4)
Direct Manufacturing Costs
Direct Materials No. of kits 1 kit per unit 150,000
Direct Labor (DL) DL hours 3.2 DL hour/unit 480,000
Direct Machining (fixed) Machine hours 300,000

Manufacturing OH Cost
Ordering
Cost per unit of Cost Driver
6

$460
$20
$38
ILLUSTRATION OF TRANSFER PRICING

Horizon Petroleum has 2 divisions, each operating as profit center. The transportation division purchases
crude oil in Matamoros (mexico) and tranports it to Houston, Texas.
Refining Division processes crude oil into gasoline. To produce gasoline: 2 barrels of crude oil to yield
1 barrel of gasoline. Transportation Division (TD) has obtained rights to purchase crude oil extracted
at $72/ barrel. The pipeline from Matamoros to Houston can transport 40,000 barrels of crude oil per day.

Refining Div. (RD) has been operating at capacity (30,000 barrels/ day), using oil supplied by TD
(average of 10,000 barr./day) and oil bought from another producer and delivered to Houston refinery
(avg 20,000 barrels/ day at $ 85)
see Exhibit 22-1 and Exhibit 22-2

Recall there are 3 methods to determine Transfer Price (TP): 1.Market based TP, 2. Cost based TP,
3. Hybrid price
1. Market based TP = $85/barrel
2. Cost based TP = 105% of full cost. Full Cost = 1.05 x ($72+ $1+$3) = $79.80
3.Hybrid TP = price between market based and Cost based TP, say $82/barr.

Regardless of the internal prices used, Company's OI =

= Revenues - Cost of crude oil purchases in Matamoros - TD Cost - RD Cost
=( $190 x 50 barr.) - ($ 72 x 100 barr) - ($ 4x 100) - ($ 14 x 50)
= $ 9500 - $ 7,200 - $400 - $700 = $1,200

A. MARKET BASED TRANSFER PRICE

Perfectly competitive Market case, TP = $85.
If TP < $85 --> managers of TD will be motivated to sell all crude oil to external buyers @$85/barr.
If TP > $85 --> manager of RD will be motivated to buy from external suppliers @$85
Only at $85/barr. Transfer price will motivate TD and RD to buy and sell internally
Results in goal congruence (actions that maximize each divisions' OI are also actions that maximize
his/her own division OI. Imperfect Competition --> selling prices affect quantity sold.

B. COST BASED TRANSFER PRICE

1. Full Cost bases
Many company uses TP based on full cost of product plus margin.
Suppose Horizon Petroleum makes internal transfers at 105% of the full cost
RD purchases on average 20,000 barrels of crude oil/day @$85 from local supplier in Houston
To reduce its costs, RD has located another supplier in Matamoros - Gulmex Corp.- that is willing to sell
20,000 barrels @$79/barr. Given company structure:
GULFMEX CORP ---> TRANSPORTATION DIV. ----> REFINING DIV.
20,000 barrels @$79/barrel
TD has unused capacity & can ship 20,000 barrels/day at its VC of $1/barrel without affecting the
shipment of 10,000 barrels under long term contract.
COMPARE INCREMENTAL COSTS IN BOTH DIVISIONS UNDER 2 ALTERNATIVES
ALT 1: Buy 20,000 barr from Houston supplier @$85/barr, TC to company = 20,000 x $85 = $1,700,000
ALT 2: Buy 20,000 barr from Gulfmex @$79/barr, and transport them to Houston @VC/barr =$1.
TC to company = 20,000 x ($79+$1) = $1,600,000

TD sells to RD is 105% of the full cost. RD's cost will increase if the crude oil is purchased from Gulfmex.
Transfer Price = 1.05 x Full Cost of TD
Transfer Price = 1.05 x (Purch.price from Gulfmex + VC/unit of TD + FC/unit of TD)
= 1.05 x ($79 + $1 + $3) = $87.15/barrel
ALT 1: Buy 20,000 barr from Houston supplier @$85/barr, TC to RD = 20,000 x $85 = $1,700,000
ALT 2: Buy 20,000 barr fromTD @$87.15/barr, TC to RD = 20,000 x $ 87.15 = $1,743,000
As profit center, RD can maximize its short run division OI by purchasing it from Houston supplier.

The full cost plus markup transfer pricing method causes RD to regard FC and 5% markup of TD as VC and
leads to goal incongruence.
Should Horizon's top managers interfere and force the refining division to buy from the transportation division?
Doing so would undercut philosophy of decentralization. Some interference would simply transform Horizon from
decentralized company into a centralized company.
What TP will promote goal congruence for both division? Minimum TP = $80, that is price paid by TD + VC/barrel
Maximum TP = $85. TP between $80 - $85 will achieve goal congruence.

2. Variable Cost bases

RD would buy from TD because TD's VC is less than $85, price charged by external supplier.
Setting transfer price equal to VC has other benefits. Knowing VC/barrel of crude oil helps RD make many decisions
such as short run pricing decisions (ch.11).
However at $80/barr, TD would record operating loss and RD would show large profits because it would be charged
only for VC of TD.

C. HYBRID TRANSFER PRICE

Recall from the above information, min TP= $80, max TP =$85
Both division would be interested in transacting each other if TP is between $80 - $85

Three ways to determine specific price within this bounds.

1. Prorating the Difference between min and max TP
a. Split difference equally = ($85 - $80)/2 = 2.5 ---> $ 82.5
but this solution ignores relative cost incurred by the two divisions and might lead to disparate profit
margins on work contributed by each division to final product.
b. Allocate the difference on the basis of VC of the two divisions.
VC of TD to transport crude oil = ($1 x 100 barrels) = $100
VC of RD to produce gasoline = ($8 x 50 barrels) = $400
Total VC $500
Allocation of VC : RD = $5 X 400 / 500 = $4, and
 TD = $5 x 100/500 = $1, then TP = $ 80 + $1 = $81
Before allocation of VC, the divisions must share information about their VC.
But, each division has an incentive to overstate its VC to receive more favorable TP.
Suppose TD claims its VC = $2/ barrel, then minimum TP = $79 + $2 = $81, max.price = $85
TD = $2 x 100 = $200
RD = $8 x 50 = $400
Total VC $600
Allocation of VC : RD = $4 X 400 / 600 = $2.67, and
TD = $4 x 200/600 = $1.33, then TP = $ 81 + $1.33 = $82.33
Proration method require high degree of trust and exchange information among divisions.

2. Negotiated Price
Negotiated price is the most common hybrid method.
Where between $80 and $85 will TP be set? The answer depends on several things:
a. bargaining set of the two divisions
b. information the TD has about the price minus incremental marketing cost of supplying crude oil to external.
c. information the RD has about its other available sources of crude oil.
Suppose RD receives an order to supply specially processed gasoline. The incremental cost $80/barrel.
RD will profit from this order only if TD can supply crude oil at a price not exceeding $82.
TP must be between $80 - $82. Negotiated TP strongly preserves autonomy of divisions &
Division managers are motivated to put forth to increase their OI

3. Dual Pricing
It is seldom a single TP simultaneously meets all criteria of fair TP.
Dual pricing uses 2 separate TP methods to price each transfer from one subunit to another.
RD as buying division will pay $85/ barrel of crude oil (market based TP)
TD as selling division will receive 105% of full cost = 1.05 x $79 = $87.15
Difference between the two TP will be accounted for by Corporate Cost account = $87.15 - $85 =
$2.15/barrel. Dual pricing systems promotes goal congruence but not widely used.

GENERAL GUIDLINE FOR TRANSFER PRICING

Minimum TP = Incremental cost perunit incurred up to the point of transfer
+ Opportunity cost perunit to selling subunit.
any decisions

d be charged