In a decentralized organization, it is not unusual for the subunits or divisions of the organization to sell and purchase goods and services to and from each other.
Transfer pricing deals with setting the price to be charged by the selling division when transacting with other divisions within the organization.
Factors to Consider in Setting the Transfer Price
Goal congruence. The transfer price should not only allow a division to achieve its own goals, but it must also be in the best interest of the entire organization. It should promote the goals of the company as a whole.
Performance evaluation. The selling division should not lose income by selling within the organization. Similarly, the buying division should not incur in very high purchase costs. The selling and buying divisions could negotiate the transfer price.
Autonomy. The transfer price should preserve autonomy. The managers of the buying and selling divisions should have the freedom to operate their divisions as separate entities.
Capacity and cost structure. The capacity of the selling division to meet the demand of the buying division should be considered. If there is excess capacity, the cost of producing the goods to be transferred is relevant. If there is no excess capacity, opportunity costs should be included in determining the transfer price.
Other factors such as tax effects and legal consequences should also be considered.
The Transfer Price
The transfer price could be based on: (1) market price, (2) cost-based price, or (3) negotiated price. Market price is applicable if there is an existing market. Cost-based price, either using variable costing or absorption costing, applies a certain mark-up above production costs. Negotiated price is a price agreed upon by the seller and buyer and is especially common when there is no existing active market for the product.
In order to promote the best interest of the selling and buying divisions (and the entire company), the transfer price is subject to upper and lower limits. The upper limit is the highest price that the seller can charge. The lower limit is the lowest price that the buyer can negotiate. The transfer price should be within the upper and lower limit.
Upper limit = Selling price in the outside market (i.e., from an outside seller)
Lower limit = Variable cost per unit plus opportunity cost per unit of the selling division
The opportunity cost refers to the lost contribution margin if the selling division has no excess capacity. If there is excess capacity, there would be no opportunity costs. Fixed costs are ignored because the same amount will be incurred regardless of the number of units produced.
Division A and Division B are independent subunits under ABC Company. Division B wants to buy 7,500 units of Division A's product every month to be used in its own operations. Division A normally sells its products for $20 per unit. Every month, Division A produces and sells 45,000 units out of its 50,000 maximum capacity. In producing 45,000 units, the company incurs $360,000 total variable costs and $200,000 total fixed costs. Division B can buy the product from an outside supplier at $22 per unit.
|Variable cost per unit||=||
There is not enough excess capacity. The 5,000 excess capacity is not enough to meet the 7,500 units demanded by Division A. Hence, Division B must sacrifice 2,500 of sales to outside customers. Hence the total contribution margin lost must be absorbed by the units to be sold to Division A.
Lost contribution margin (CM) = 2,500 unit x ($20 - $8) = $30,000
|Lost CM per unit||=||
Lower limit = $8 variable cost + $4 lost CM = $12
The upper limit is the selling price of outside suppliers. Division B can buy the product for $22 each from an outside supplier. Therefore, the upper limit is $22.
The transfer price should be within $12 and $22. This will ensure that the selling division will not incur losses and that the buying division will not spend more that what it can pay an outside supplier.