TRANSFER PRICING

Transfer Price is the monetary value, or the price charged by one segment of a firm for the goods and services it supplies to
another segment of the same firm.

Objectives of Transfer Pricing:

 To facilitate optimal decision-making.
 To provide a basis in measuring divisional performance.
 To motivate the different department heads in improving their performance and that of their departments.
Basis of Transfer Price:
 Cost-Based Price
 Market-Based Price
 Negotiated Price
 Arbitrary Price

General Rules in Choosing a Transfer Price:

 The maximum price should be no greater than the lowest market price at which the buying segment can acquire
the goods or services externally.
 The minimum price should be no less than the sum of the selling segment’s incremental costs associated with the
goods or services plus the opportunity cost of the facilities used.
 A good should be transferred internally whenever the minimum transfer price (set by the selling division) is less than
the maximum transfer price (set by the buying division). By doing this, total profits of the firm are not decreased by an
internal transfer.

Maximum vs. Minimum Transfer Prices

To minimize the effect of sub-optimization, a range for transfer price must be set based on the following limits:
 Maximum transfer price: Cost of buying from outside suppliers
 Minimum transfer price: Variable cost per unit + Lost Contribution Margin per unit on outside sales
o When a company segment is operating at full capacity, the lost CM per unit on outside sales is the opportunity
cost of transferring products to another company segment.
Internal Sales
o The transfer of goods between divisions of the same company is called internal sales. Divisions within vertically
integrated companies normally sell goods to other company divisions as well as to outside customers.
o The charge for labor time is expressed as a rate per labor
 The direct labor cost of the employee (hourly rate or salary and fringe benefits).
 Selling, administrative, and similar overhead costs.
 An allowance for a desired profit or ROI per hour of employee time.
o The charge for materials typically includes a material loading charge which covers the costs of purchasing,
receiving, handling, and storing materials, plus any desired profit margin on the materials themselves.
o The charges for any particular job are the sum of the:
 Labor charge
 Charge for materials
 Material loading charge

Cost-Based Transfer Prices

o One method of determining transfer prices is to base the transfer price on the costs incurred by the division
producing the goods.
o A cost-based transfer price may be based on full cost, variable cost, or some modification including a markup.
o The cost-based approach often leads to poor performance evaluations and purchasing decisions. Under this
approach, divisions sometimes use improper transfer prices which leads to a loss of profitability and unfair
evaluations of division performance.
o The cost-based approach does not provide the selling division with proper incentive. In addition, this approach
does not reflect the selling division’s true profitability and doesn’t even provide adequate incentive for the
selling division to control costs since the division’s costs are passed on to the buying division.

Absorption Cost Approach

o The absorption cost approach uses total manufacturing cost as the cost base and provides for
selling/administrative costs plus the target ROI through the markup.
o The absorption cost approach involves three steps:
 Compute the unit manufacturing cost.
 Compute the markup percentage (the percentage must cover both the desired ROI and selling and
administrative expenses).
 Set the target selling price.

The markup percentage is computed by dividing the sum of the desired ROI per unit and selling and administrative expenses per
unit by the manufacturing cost per unit.
o The target selling price is computed as: Manufacturing cost per unit + (Markup percentage X Manufacturing cost per
unit).
Variable Cost Pricing
 Variable cost pricing uses all of the variable costs, including selling and administrative costs, as the cost base and
provides for fixed costs and target ROI through the markup.
 Variable cost pricing is more useful for making short- run decisions because it considers variable cost and fixed
cost behavior patterns separately.
 Variable cost pricing involves the following steps:
o Compute the unit variable cost.
o Compute the markup percentage.
o Set the target selling price.
 The markup percentage is computed by dividing the sum of the desired ROI per unit and fixed costs per unit by the
variable cost per unit.
 The target selling price is computed as: Variable cost per unit + (Markup percentage X Variable cost per unit).
 The specific reasons for using variable cost pricing are:
o It is more consistent with cost-volume-profit analysis used to measure the profit implications of changes in
price and volume.
o This approach provides the type of data managers need for pricing special orders.
o It avoids arbitrary allocation of common fixed costs to individual product lines.

Market Based Transfer Prices

o The market-based transfer price is based on existing market prices of competing goods. This system is often
considered the best approach because it is objective and generally provides the proper economic incentives.
o When the selling division has no excess capacity, it receives market price and the purchasing division pays market
price.
o If the selling division has excess capacity, the market based system can lead to actions that are not in the best interest
of the company.

Negotiated Transfer Prices

o Under negotiated transfer pricing, the selling division, establishes, a minimum transfer price and the purchasing
division establishes a maximum transfer price.
o Companies often do not use negotiated transfer pricing because:
 Market price information is sometimes not easily obtainable.
 A lack of trust between the two negotiating divisions may lead to a breakdown in negotiations.
 Negotiations often lead to different pricing strategies from division to division which is sometimes
costly to implement.

THEORY

1. The price that one division of a company charges another division for goods or services provided is called
the:
a. Market price c. Outlay price
b. Transfer price d. Distress price

2. From the standpoint of the company, the important question in transfer pricing is
a. What is fair to the divisions c. Whether or not the transfer should take place
b. How to determine the profit of the divisions d. When the transfer should be made

3. As a general rule, the best transfer price to use to transfer the costs of a service center
to an operating department is
a. The price charged by an outside company for the same service
b. The price that encourages goal congruence
c. One that is based on budgeted variable cost
d. One that is based on budgeted total cost

4. Which of the following is a consistently desirable characteristic in a transfer pricing system?

a. System is very complex to be the most fair to the buying and selling units
b. Effect on subunit performance measures is not easily determined
c. System should reflect organizational goals
d. Transfer price remains constant for a period of at least two years

5. In a decentralized company in which divisions may buy goods from one another, the transfer
pricing system should be designed primarily to
a. Minimize the degree of autonomy of division managers
b. Aid in the appraisal and motivation of managerial performance
c. Increase the consolidated value of inventory
d. Discourage division managers from buying from outsiders

6. Market-based transfer prices are best for

a. The company when the selling division is operating below capacity
b. The company when the selling division is operating at capacity
 c. The buying division if it is operating at capacity
d. The buying division

7. Given a competitive outside market for identical intermediate goods, what is the best
transfer price, assuming all relevant information is readily available?
a. Average cost of production
b. Average cost of production plus average production department's allocated profit
c. Market price of the intermediate goods
d. Market price of the intermediate goods less average production department's allocated profit

8. The transfer pricing method that allows managers the greatest degree of authority and
control over the profit of their units is
a. Market pricing c. Cost
b. Arbitrary methods d. Negotiated pricing

9. Which of the following is the most valid reason for not using a cost-plus transfer price
between decentralized units of a company? A cost-plus transfer price
a. Does not reflect the excess capacity of the supplying unit
b. Is typically more costly to implement
c. Does not ensure the control of costs of a supplying unit
d. Is not available unless market-based prices are available

10. The most valid reason for using something other than a full-cost-based transfer price
between units of a company is because a full-cost price
a. Is typically more costly to implement
b. Does not ensure the control of costs of a supplying unit
c. Is not available unless market-based prices are available
d. Does not reflect the excess capacity of the supplying unit

11. With two autonomous division managers, the price of goods transferred between the
divisions needs to be approved by
a. Corporate management
b. Both divisional managers
c. Both divisional managers and corporate management
d. Corporate management and the manager of the buying division
12. The minimum potential transfer price is determined by
a. Incremental costs in the selling division
b. The lowest outside price for the good
c. The extent of idle capacity in the buying division
d. Negotiations between the buying and selling division

13. Which of the following is true about transfer prices for sales between divisions located in different
countries?
a. They should consider the tax structures in the two countries
b. They are usually set by the governments of the two countries
c. They cannot affect the total income of the company
d. All of the above

PROBLEMS

1. Victoria Corporation produces various products used in the construction industry. The P
Division produces and sells 100,000 copper fittings each month. Relevant information for last
month follows:

Total sales (all external) P250,000

Expenses (all on a unit base):
Variable manufacturing P0.50
Fixed manufacturing .25
Variable selling .30
Fixed selling .40
Variable G&A .15
Fixed G&A .50
Total P2.10
Question 1: Top-level managers are trying to determine how a transfer price can be set on a
transfer of 10,000 of the copper fittings from the P Division to the B Division. A transfer price
based on variable cost will be set at
per unit.
a. P 0.50 c. P 0.95
b. P 0.80 d. P 0.75
 Question 2: A transfer price based on full production cost would be set at per unit.
a. P 0.75 c. P 1.45
b. P 2.10 d. P 1.60
Question 3: A transfer price based on market price would be set at per unit.
a. P 2.10 c. P 1.60
b. P 2.50 d. P 2.25
Question 4:
If the P Division is operated as an autonomous investment center and its capacity is 100,000
fittings per month, the per-unit transfer price is not likely to be below
a. P 0.75 c. P 2.10
b. P 1.60 d. P 2.50

2. Ella Corporation manufactures and sells various high-tech office automation products. Two
divisions of the company are the C Division and the D Division. The C Division manufactures
one product, a "super chip," that can be used by both the D Division and other external
customers. The following information is available on this month's operations in the C Division:

Selling price per chip P50

Variable costs per chip P20
Fixed production costs P60,000
Fixed SG&A costs P90,000
Monthly capacity 10,000 chips
External sales 6,000 chips
Internal sales 0 chips

Presently, the D Division purchases no chips from the C Division, but

instead pays P45 to an external supplier for the 4,000 chips it needs each
month.
Question 4: If a transfer between the two divisions is arranged next period at a price (on 4,000
units of super chips) of P40, total profits in the C division will
a. Rise by P20,000 compared to the prior period
b. Drop by P40,000 compared to the prior period
c. Drop by P20,000 compared to the prior period
d. Rise by P80,000 compared to the prior period
Question 5: Assume, for this question only, that the C Division is selling all that it can produce
to external buyers for P50 per unit. How would overall corporate profits be affected if it sells
4,000 units to the D Division at P45? (Assume that the D Division can purchase the super chip
from an outside supplier for P45.)
a. No effect c. P20,000 decrease
b. P20,000 increase d. P90,000 increase

3. Angelika Company has two divisions: The C Division and the B Division. The B Division
produces containers that can be used by the C Division. The B Division's variable
manufacturing cost is P2, shipping cost is P0.10, and the external sales price is P3. No shipping
costs are incurred on sales to the C Division, and the C Division can purchase similar
containers in the external market for P2.60.

Question 1: The B Division has sufficient capacity to meet all external market demands in
addition to meeting the demands of the C Division. Using the general rule, the transfer price
from the B Division to the C Division would be:
a. P 2.00 c. P 2.60
b. P 2.10 d. P 2.90
Question 2: Assume the B Division has no excess capacity and could sell everything it produced
externally. Using the general rule, the transfer price from the B Division to the C Division would
be:
a. P 2.00 c. P 2.60
b. P 2.10 d. P 2.90
Question 3: The maximum amount the C Division would be willing to pay for each bottle transferred would
be:
a. P 2.00 d. P 2.60
b. P 2.10 d. P 2.90
4. Division A makes a part that it sells to customers outside of the Jomer Company. Data
concerning this part appear below:

Selling price to outside customers ......................... P40

Variable cost per unit ............................................. P30
Total fixed costs ...................................................... P10,000
Capacity in units ..................................................... 20,000
 Division B of the same company would like to use the part manufactured by Division A in one
of its products. Division B currently purchases a similar part made by an outside company for
P38 per unit and would substitute the part made by Division A. Division B requires 5,000 units
of the part each period. Division A is already selling all of the units it can produce to outside
customers. If Division A sells to Division B rather than to outside customers, the variable cost
per unit would be P1 lower. What is the lowest acceptable transfer price from the standpoint
of the selling division?
a. P 40 c. P 38
b. P 39 d. P 37

5. Division P of the Kenshemrock Company makes a part that can either be sold to outside
customers or transferred internally to Division Q for further processing. Annual data relating
to this part are as follows:

Annual production capacity .................................................. 80,000 units

Selling price of the item to outside customers ..................... P35
Variable cost per unit............................................................ P23
Fixed cost per unit ................................................................ P5

Division Q of the company requires 15,000 units per year and is currently paying an outside
supplier P33 per unit. Consider each part below independently.
Question 1: If outside customers demand only 50,000 units per year, what is the lowest
acceptable transfer price from the viewpoint of the selling division?
a. P 35 c. P 28
b. P 33 d. P 23
Question 2: If outside customers demand 80,000 units, what is the lowest acceptable transfer
price from the viewpoint of the selling division?
a. P 35 c. P 28
b. P 33 d. P 23
Question 3: If outside customers demand 80,000 units and if, by selling to Division Q, Division
P could avoid P4 per unit in variable selling expense, what is the lowest acceptable transfer
price from the viewpoint of the selling division?
a. P 35 c. P 31
b. P 21 d. P 33
Question 4: If outside customers demand 70,000 units, what is the lowest acceptable transfer
price from the viewpoint of the selling division for each of the 15,000 units needed by Q?
a. P 33 c. P 28
b. P 27 d. P 29