UNIT VI:

TRANSFER PRICING
Learning Outcome
• Introduction
• Objectives of transfer pricing
• Identify and assess different approaches to transfer pricing
Sub-topics
• 6.1 Introduction
• 6.2 Objectives of transfer pricing
• 6.3 Approaches to/ Methods of setting the transfer price:
• 6.3.1 Cost Based Transfer Pricing
• 6.3.2 Full Cost Method
• 6.3.3 Standard Cost Method
• 6.3.4 Cost Plus Mark Up Method
• 6.3.5 Market Price Based Transfer Pricing
• 6.3.6 Negotiated Transfer Pricing
• 6.3.7 Dual Rate of Transfer Pricing
• 6.3.8 Shared profit in relation to cost
• 6.4 Potential interpersonal conflicts in transfer pricing
• 6.5 The selling divisions lowest acceptable transfer price
• 6.6 The purchasing division highest acceptable transfer price
• 6.7 Selling division with idle capacity, no outside supplier, transfer at the cost to the selling division, transfer at
market price
• 6.8 International aspects of transfer pricing
Introduction
A transfer price is that notional value at which goods and services are transferred between divisions in a
decentralized organization
 Introduction
• In the modern days, production is on the mass scale due to technological advancement and upgradation.
Organizations grow in course of time and for such growing organizations, decentralization becomes
necessary. It becomes inevitable for such organizations to establish separate divisions and departments to
ensure smooth working

• Transfer pricing has become necessary in highly decentralized companies where number of
divisions/departments are created as a part and parcel of the decentralized organization. Transfer pricing is
one of the tools in the hands of management for measuring the performance of divisions or departments.

• Transfer prices are normally set for intermediate products, which are goods, and services that are supplied by the
selling division to the buying division. In large organizations, each division is treated as a ‘profit centre’ s a part and
parcel of decentralization. Their profitability is measured by fixation of ‘transfer price’ for inter divisional transfers.

• The transfer price can have impact on the division’s performance and hence lot of care is to be taken in fixation of
the same.
 The following factors should be taken into consideration before fixing the
transfer prices.

1.Transfer price should help in the accurate measurement of divisional performance

2.It should motivate the divisional managers to maximize the profitability of their divisions
3.Autonomy and authority of a division should be ensured.
4.Transfer price should allow ‘ goal congruence’ which means that the objectives of divisional
managers match with those of the organization.
Example 1.
• Take the following scenario, in which Division A makes components for a cost
of $30, and these are transferred to Division B for $50. Division B buys the
components in at $50, incurs own costs of $20, and then sells to outside
customers for $90.
Example 2.
In the following examples, assume that Division A can sell only to Division B,
and that Division B can only buy from Division A. Example 1 has been
reproduced but with costs split between variable and fixed. At the transfer price
of $50 given, this allows each division to make a profit of $20.

Use the cost based approach to fix the transfer price

Class Activity
The Y Company has two divisions, A and B. Division A manufactures goods,
which transfer to Division B for further processing and packaging. Division A
manufactures goods at a cost of Nu. 100 per unit, which includes cost of
materials of Nu. 50 cost of labour Nu. 30 and fixed cost at Nu. 20. Division B
incurs additional variable and fixed cost of Nu. 15 and Nu. 10 respectively.

• Calculate the transfer price under Cost based pricing methods as follows:
• Variable cost plus 10% mark up
• Total cost plus 10% mark up

• Determine the selling price of the manufactured goods in each scenarios?

Example 3.
• Consider Example 1 again, where the transfer price had been set at $50, but
this time assume that the intermediate product can be sold to, or bought from,
the market at a price of $40.
Objectives of inter- company transfer pricing
• To evaluate the current performance and profitability of each individual unit

This is necessary in order to determine whether a particular unit is competitive and

can stand in its working. When the goods are transferred from one department to
another, the revenue of one department becomes the cost of another and such inter
transfer price affects the reported profits.
• To improve the profit position:

Intercompany transfer price will make the unit competitive so that it may maximize
its profit and contribute to the overall profits of the organization.
• To assist in decision making:

Correct intercompany transfer price will make the costs of both the units realistic in
order to take decisions relating to such problems as make or buy, sell or process
further, choice between alternative methods of production.
• For accurate estimation of earnings on proposed investment decisions:

When finance is scare and it is required to determine the allocation of scarce

resources between various divisions of the concern taking into consideration their
competing claims, then this technique is useful.
 Methods of fixing transfer price
1. Pricing based on cost.
(a) Actual cost
(b) Cost plus
(c) Standard cost
(d) Marginal cost
2. Market price as transfer price.
3. Negotiated pricing.
4. Pricing based on Opportunity cost.
Pricing based on cost
In these methods, cost is the base and the following methods fall under this
category.
• Actual cost: under this method the actual cost of production is taken as
transfer price for inter divisional transferors. Such actual cost may consist of
variable cost or sometimes total costs including fixed costs.

• Cost plus: under this method, transfer price is fixed by adding a reasonable
return on capital employed to the total cost. Thereby the measurement of profit
becomes easy.
 Pricing based on cost
• Standard cost: under this method, transfer price is fixed on the basis on standard cost. The
difference between the standard cost and the actual cost being variance is absorbed by
transferring division. This method is simple and easy to follow, but the constant revision of
standards is necessary at regular intervals.

• Marginal cost: under his method, the transfer price is determined on the basis of marginal cost.
The reason being fixed cost is in any case unavoidable and hence should not be charged to the
buying division. That is why only marginal cost will be taken as transfer price
 Market price as transfer price
• Under this method, the transfer price will be determined according to the market price prevailing in the market.

• It acts as a good incentive for efficient production to the selling division and any inefficiency in production and
abnormal costs will not be bone by the buying division.

• One of the variation of this method is that from the market price, selling and distribution overheads should be
deducted and price thus arrived should be charged as transfer price. The reason behind this is that no
selling efforts are required to sale the goods/services to the buying division and therefore these costs should not
be charged to the buying division
 Market price based transfer price has the following advantages :

• Actual costs are fluctuating and hence difficult to ascertain. On the other hand
market prices can be easily ascertained.

• Profits resulting from market price based transfer prices are good parameters for
performance evaluation of selling and buying divisions.

• It avoids extensive arbitration system in fixing the transfer prices between the
divisions
 Limitations of Market Price

• There may be resistance from the buying division. They may question buying from

the selling division if in any way they have to pay the market prices.
• Like cost based prices, market prices may also be fluctuating and hence there may

be difficulties in fixation of these prices.

• Market price is a rather vague term as such prices may be ex-factory price,

wholesale price, retail price etc.

 Limitations of Market Price
• Market prices may not be available for intermediate products, as these products
may not have any market.

• This method may be difficult to operate if the intermediate products is for

captive consumption.

• Market price may change frequently

• Market prices may not be ascertained easily.

 Negotiated transfer price
• Under this method, the transfer prices may be fixed through negotiations between the selling and the buying
division. Sometimes it may happen that the concerned product may be available in the market at a cheaper
price than charged by the selling division.

The main limitation of this method is that lot of time is spent by both the negotiating parties in fixation of
the negotiated prices.

• Negotiating skills are required for the managers for arriving at a mutually acceptable price, otherwise
there is a possibility of conflicts between the divisions
 Pricing based on opportunity cost
• This pricing recognizes the minimum price that the selling division is ready to
accept and the maximum price that the buying division is ready to pay.

• The final transfer price may be based on these minimum expectations of both
the divisions. The most ideal situation will be when the minimum price expected
by the selling division is less than the maximum price accepted by the buying
division.

• However in practice, it may happen very rarely and there is possibility of conflicts
over the opportunity cost.
 The range of acceptable negotiated transfer prices

*** When there is idle capacity, there are no lost sales and so the total contribution
margin of lost sales is zero
 Transfer Pricing When Selling Division Is below Capacity

• No opportunity cost of selling internally since no outside sales are foregone as

a result of the transaction

• Transfer price = differential cost to selling division + opportunity cost of selling

internally
 Transfer Pricing When Selling Division Is at Capacity

• This create an opportunity cost of selling internally, since outside sales must
be foregone as a result of the transaction
• Transfer price = differential cost to selling division + opportunity cost of selling
internally
Example
• Division A is a profit Centre which produces three products X, Y and Z. Each product has an external market

X Y Z
External marker price per unit Nu.48 Nu. 46 Nu.40
Variable cost of production in division A Nu. 33 Nu. 24 Nu. 28
Labour hours required per unit in division A 3 4 2
Maximum sales in units 800 500 300
• Product Y can be transferred to Division B, but the maximum quantity that might be required for transfer is
300 units of Y.
• Instead of receiving transfers of Product Y from Division A, Division B could buy similar product in the open
market at a slightly cheaper price of `45 per unit.
What should the transfer price be for each unit for 300 units of Y, if the total labour hours available in Division
A are?
(a) 3800 hours
(b) 5600 hours.
 Dual-rate Transfer prices
• The system permits the use if two rate, one for the selling division and one for
the buying division.

• This system would preserve cost data for subsequent buyer departments, and
would encourage internal transfer by providing profit on such transfers for the
selling division
 Shared Profit in Relation to Cost
• The profit or the contribution of a company as a whole is computed and
shared among its division on the basis of total cost or variable cost.

• This method does not motivate the divisional managers to reduce cost,
because greater the cost greater will be the profit or contribution allocated to
the division
 International Aspects of Transfer Pricing
• The objectives of international transfer pricing, as compared to domestic
transfer pricing are summarized below
 In class activity
• A company is organized into two division, A and B. Each month Division A
buys 10,000 kgs of Chemvax at a price of Nu. 34 per kg from the external
market. Division B manufactures 40,000 kg of chemvax for external market at
a variable cost of Nu. 25 per kg. The fixed costs of Division B amount to Nu.
500,000 per month. The external selling price that Division B charges is Nu. 40
per kg.
• 1)Will division B be able to transfer 10,000 kg of chemvax to Division A at a
price of Nu. 34 per kg if its capacity is to produce 40,000 kg?
• 2) If the capacity of Division B is 55,000 kg per month will the two division be
able to arrive at a transfer price?
• 3) If the capacity of Division B is 45,000 kg and the external demand is 40,000
kg per month, what should be transfer price?