Which of the following transfer pricing methods always achieves goal congruence

A transfer price set at full cost, as shown in Table 3 is slightly more satisfactory for Division A as it means that it can aim to break even. Its big drawback, however, is that it can lead to dysfunctional decisions because Division B can make decisions that maximise its profits, but which will not maximise company profits.  For example, if the final market price fell to $35, Division B would not trade because its marginal cost would be $40 (transfer-in price of $30 plus own marginal costs of $10). However, from a group perspective, the marginal cost is only $28 ($18 + $10) and a positive contribution would be made even at a selling price of only $35. Head office could, of course, instruct Division B to trade but then divisional autonomy is compromised, and Division B managers will resent being instructed to make negative contributions which will impact on their reported performance.

The full cost plus approach would increase the transfer price by allowing division A to add a mark-up. This would now motivate Division A, as profits can be made there and may also allow profits to be made by Division B. However, again this can lead to dysfunctional decisions as the final selling price falls.

Once you move away from a transfer price equal to the variable cost in the transferring division, there is always the risk of dysfunctional decisions being made unless an upper limit – equal to the net marginal revenue in the receiving division – is also imposed.

Where there is a market for the intermediate product

The setting of a transfer price is complicated where there is an external market for the product – ie where the selling division can sell the product externally, and, or the buying division can buy the product externally. Always read the scenario carefully in a transfer pricing question to find out if the product being transferred can be sold or bought externally as this can affect the transfer price which should be set.

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.

Division A would rather transfer internally to Division B, because receiving $50 is better than receiving $40. However, Division B would rather buy externally at the cheaper price of $40. If Division B buys externally, this would be bad for the company because there is now a marginal cost to the company of $40 instead of only $18 (the variable cost of production in Division A).

In an exam question, it is important to be able to discuss this type of situation. It can be useful to consider the minimum and maximum transfer prices that each division would accept. In discussing transfer prices, think about:

• What would the selling division prefer to do and how would this affect the buying division and the company?
• What would the buying division prefer to do and how would this affect the selling division and the company?

Minimum transfer price
When considering the minimum transfer price, look at transfer pricing from the point of view of the selling division. The question we ask is: what is the minimum selling price that the selling division would be prepared to sell for? Note that this will not necessarily be the same as the price that the selling division would be happy to sell for, although, as you will see, if it does not have spare capacity, it is the same.

The minimum transfer price that should be set if the selling division is to be happy is:

marginal cost + opportunity cost.

Opportunity cost is defined as the 'value of the best alternative that is foregone when a particular course of action is undertaken'. Given that there will only be an opportunity cost if the seller does not have any spare capacity, the first question to ask is therefore: does the seller have spare capacity? 

Spare capacity
If there is spare capacity, then, for any sales that are made by using that spare capacity, the opportunity cost is zero. This is because workers and machines are not fully utilised. So, where a selling division has spare capacity the minimum transfer price is effectively just marginal cost. However, this minimum transfer price is probably not going to be one that will make the managers happy as they will want to earn additional profits. So, you would expect them to try and negotiate a higher price that incorporates an element of profit.

No spare capacity
If the seller doesn’t have any spare capacity, or it does not have enough spare capacity to meet all external demand and internal demand, then the next question to consider is: how can the opportunity cost be calculated? Given that opportunity cost represents contribution foregone, it will be the amount required in order to put the selling division in the same position as they would have been in had they sold outside of the group.

Logically, the buying division must be charged the same price as the external buyer would pay, less any reduction for cost savings that result from supplying internally. These reductions might reflect, for example, packaging and delivery costs that are not incurred if the product is supplied internally to another division.

It is not really necessary to start breaking the transfer price down into marginal cost and opportunity cost in this situation, it can simply be calculated as the external market price less any internal cost savings.

At this transfer price, the selling division would make just as much profit from selling internally as selling externally. Therefore, it reflects the price that they would actually be happy to sell at. They should not expect to make higher profits on internal sales than on external sales.

Maximum transfer price
When we consider the maximum transfer price, we are looking at transfer pricing from the point of view of the buying division. The question we are asking is: what is the maximum price that the buying division would be prepared to pay for the product? The answer to this question is very simple and the maximum price will be one that the buying division is also happy to pay.

The maximum price that the buying division will want to pay is the market price for the product – ie whatever they would have to pay an external supplier. If this is the same as the selling division sells the product externally for, the buyer might reasonably expect a reduction to reflect costs saved by trading internally.

In an exam answer, be willing to discuss the minimum and maximum transfer prices and how each division would react to them.

Summary

The level of detail given in this article reflects the level of knowledge required for Performance Management. It is important to understand the purpose of transfer pricing, its impact on performance measurement, motivation and decision making and to be able to work out a reasonable transfer price/range of transfer prices.

Written by a member of the Performance Management examining team