Accounting: The Language of Business - Vol. 1 (Part 146)

There are three cardinal rules - don't take somebody else's boyfriend unless you've been specifically invited to do so, don't take a drink without being asked, and keep a scrupulous accounting in financial matters.

W. H. Auden

Performance Evaluation for Decentralized Operations (Part E)

by

Charles Lamson

Transfer Pricing

When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services. Since transfer prices affect the goals for both divisions, setting these prices is a sensitive matter for division managers. 

Transfer prices should be set so that overall company income is increased when goods are transferred between divisions. As we will illustrate, however, transfer prices may be misused in such a way that overall company income suffers.

In the following paragraphs, we discuss various approaches to setting transfer prices. Exhibit 8 shows the range of prices that results from common approaches to setting transfer prices. Transfer prices can be set as low as the variable cost per unit or as high as the market price. Often, transfer prices are negotiated at some point between variable cost per unit and market price.

EXHIBIT 8 Commonly Used Transfer Prices

Transfer prices may be used when decentralized units are organized as cost, profit or investment centers. To illustrate, we will use a packaged snack food company (Wilson Company) with no service departments and two operating divisions (Eastern and Western) organized as investment centers. Condensed divisional income statements for Wilson Company, assuming no transfers between divisions, are shown in Exhibit 9.

EXHIBIT 9 Income Statement---No Transfers Between Divisions

Market Price Approach

Using the market price approach the transfer price is the price at which the product or service transferred could be sold to outside buyers. If an outside market exists for the product or service transferred, the current market price may be a proper transfer price.

To illustrate, assume that materials used by Wilson Company in producing snack food in the Western Division are currently purchased from an outside supplier at $20 per unit. The same materials are produced by the Eastern Division. The Eastern Division is operating at full capacity of 50,000 units and can sell all it products to either the Western Division or to outside buyers. A transfer price of $20 per unit (the market price) has no effect on the Eastern Division's income or total company income. The Eastern Division will earn revenues of $20 per unit on all its production and sales, regardless of who buys its product. Likewise, the Western Division will pay $20 per unit for materials the (the market price). Thus, the use of the market price as the transfer price has no effect on the Eastern Division income or total company income. In this situation, the use of the market price as the transfer price is proper. The condensed divisional income statements for Wilson Company in this case are also shown in Exhibit 9.

Negotiated Price Approach

If unused or excess capacity exists in the supplying division (the Eastern Division), and the transfer price is equal to the market price, total company profit may not be maximized. This is because the manager of the Western Division will be indifferent toward purchasing materials from the Eastern Division or from outside suppliers. Thus, the Western Division may purchase the materials from outside suppliers. If, however, the Western Division purchases the materials from the Eastern Division, the difference between the market price of $20 and the variable costs of the Eastern Division can cover fixed costs and contribute to company profits. When the negotiated price approach is used in this situation, the manager of the western division is encouraged to purchase the materials from the Eastern Division.

The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves as to the transfer price. The only constraint on the negotiations is that the transfer price be less than the market price but greater than the supplying division's variable costs per unit.

To illustrate the same use of the negotiated price approach, assume that instead of a capacity of 50,000 units, the Eastern Division capacity is 70,000 units. In addition, assume that the Eastern Division can continue to sell only 50,000 units to outside buyers. A transfer price less than $20 would encourage the manager of the Western Division to purchase from the Eastern Division. This is because the Western Division's materials cost per unit would decrease, and its income from operations would increase. At the same time, a transfer price above the Eastern Division's variable cost per unit of $10 (from Exhibit 9) would encourage the manager of the Eastern Division to use the excess capacity to supply materials to the Western Division. In doing so, the Eastern Division's income from operations would increase.

We continue the illustration with the aid of Exhibit 10, assuming that Wilson Company's division managers agree to a transfer price of $15 for the Eastern Division's product. By purchasing from the Eastern Division, the Western Division's materials cost would be $5 per unit less. At the same time, the Eastern Division would increase its sales by $300,000 (20,000 units * $15 per unit) and increase its income by $100,000 ($300,000 sales - $200,000 variable costs).The effect of reducing the Western Division's materials cost by $100,000 (20,000 units * $5 per unit) is to increase its income by $100,000. Therefore, Wilson Company's income is increased by $200,000 ($100,000 reported by the Eastern Division and $100,000 reported by the Western Division), as shown in the condensed income statement in Exhibit 10.

EXHIBIT 10 Income Statements---Negotiated Transfer Price

In this illustration, any transfer price less than the market price of $20 but greater than the Eastern Division unit variable costs of $10 would increase each division's income. In addition, overall company profit would increase by $200,000. By establishing a range of $20 to $10 for the transfer price, each division manager has an incentive to negotiate the transfer of the materials.

Cost Price Approach

Under the cost price approach, cost is used to set transfer prices. With this approach, a variety of cost concepts may be used. For example, cost may refer to either total product cost per unit or variable product cost per unit. If total product cost per unit is used, direct materials, direct labor, and factory overhead are included in the transfer price. If variable product cost per unit is used, the fixed factory overhead component of total product cost is excluded from the transfer price.

Either actual costs or standard (budgeted) costs may be used in applying the cost price approach. If actual costs are used, and efficiencies of the producing division are transferred to the purchasing division. Thus, there is little incentive for the producing division to control costs carefully. For this reason, most companies use standard cost in the cost price approach. In this way, differences between actual and standard costs remain with the producing division for cost control purposes.

When division managers have responsibility for cost centers, the cost price approach to transfer pricing is proper and is often used. The cost price approach may not be proper, however, for decentralized operations organized as profit or investment centers. In profit and investment centers, division managers have responsibility for both revenues and expenses. The use of cost as a transfer price ignores the supplying division manager's responsibility for revenues. When a supplying division's sales are all intracompany transfers, for example, using the cost price approach prevents the supplying division from reporting any income from operations. A cost-based transfer price may therefore not motivate the division manager to make intracompany transfers, even though they are in the best interest of the company. 

*WARREN, REEVE, FESS, 2005, ACCOUNTING, 21ST ED., PP. 966-969*

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