Transfer Price Models
Generally, the decision of which model to use is made by top management and should take into
account the goals of the entire company, while at the same time maintaining motivation of the
departments. The more common models are market price, cost of production plus opportunity cost, negotiated price, variable cost, and full cost.
Firms often combine various methods (dual pricing) to match their needs.
Market price model
Market price is the price on open market.
The market price model is a true arm’s length model because it sets the price for a good or service at going market prices. This model can be used only when:
1- An item has a market; items such as work-in-process inventory may not have a market
price.
2- The market is competitive (i.e.) the supplying division can sell its product or service externally as well as internally. Also the receiving division can’t get the product or service from an outside source at a lower price.
3- All capacity of the supplying division is used and no idle capacity exists.
Note: if some idle capacity exists then the opportunity cost for the supplying division would be zero.
4- Interdivisional dependency is low (i.e.) highly decentralized company. In this case the buying and selling divisions would be indifferent to buy or sell internally or externally under these circumstances a market price would be consistent with divisional autonomy and would promotes goal congruence and management effort, (i.e.) each divisional manager will take actions that maximize the organization’s goals as well as their own goals.
Market transfer price model keeps business units autonomous, forces the selling unit to be
competitive with external suppliers, and is preferred by tax authorities. Businesses that use this
model should account for the reduced selling and marketing costs in the price. Means that,
Market price could be the sum of the outlay cost (cash outflows of the supplying division)
plus opportunity costs of the supplying division, this price would be the minimum acceptable
price for the supplying division.
Market price is the optimal method for establishing a transfer price because Market price is
objective.
Using Market transfer price under previous mentioned circumstances would avoid waste and
maximize efficiency. Thus market price should be used as the transfer price to avoid waste and
maximize efficiency in a competitive economy. This price also measures the product’s
profitability and the division managers’ performance in a competitive environment. Overall longterm competitiveness is enhanced with a market based transfer price. Thus market based prices provide market discipline because efficient internal suppliers will tend to prosper.
Notes:
- Market price could be the retail price assuming an arm’s length transaction.
- The opportunity costs are the maximum contribution forgone by the supplying division if the goods/services are sold internally. An opportunity cost will exist if the supplier has no idle capacity and an external market exists.
EX: The alpha division of a company, which is operating at capacity, produces and sells 1,000 units of a certain electronic component in a perfectly competitive market. Revenue and cost data are as follows:
Sales $50,000
Variable costs $34,000
Fixed costs $12,000
The minimum transfer price that should be charged to the beta division of the same company for each component is the market price $50,000 ÷ 1,000 units = $50 per unit
Cost of production plus opportunity Cost
This is a calculation that includes not only the cost of production (called outlay cost), but also the contribution margin that the selling department is giving up by selling the product internally rather than externally. Though this approximates a market price, it is not exactly a market price because a true market price may only be set in an arm’s length transaction, which this is not.
Negotiated (Bargained) Price Model
The negotiated price model sets the transfer price through negotiation between the subunit buyer and the subunit seller. When different business units experience conflicts, negotiation or even arbitration may be needed to keep the company as a whole functioning efficiently.
This method is going to be the most useful when the products in a market are rapidly changing and the companies need to be able to react quickly to changes in the market place.
Negotiated prices can make both buying and selling units less autonomous, especially if top
management interfered with transfer price determination.
However, in order to be effective, neither negotiating party should have an unfair bargaining
position. A drawback of this method is that negotiation can be time-consuming and require frequent revision of prices because of changing costs and market conditions. Time required for negotiating diverts the attention of division managers away from more productive activities that would benefit the company, to activities that benefit the division. And the resulting division profits may be more a measurement of the manager’s negotiating ability than the division’s productive efficiency.
Conditions required for negotiating a transfer price
- Outside markets exist to give both parties alternatives to dealing with each other.
- Both parties have access to market price information.
- Both parties are free to buy and sell outside the corporation.
- Top management supports the continuation of the decentralized arrangement.
Cost based Models
1- Variable Cost Model (called outlay cost/ Marginal or incremental cost)
The variable cost model sets transfer prices at the unit’s variable cost (manufacturing V.C or total V.C)
The transfer price could be based on variable cost only (actual or standard) or variable cost plus markup (either an amount or %)
Variable cost plus markup transfer price is the price set by charging for variable cost plus either a lump sum or an additional markup, but less than full markup price.
Variable cost model will lower the selling unit’s profits and increase the buying unit’s profits due to the low price. This works well if the selling division has excess capacity and when the main objective of the transfer price is simply to satisfy the internal demand for goods, it is not appropriate if the seller is a profit or investment unit,
V.C plus markup is advantageous for selling units that have excess capacity or for situations
when a buying unit could purchase from external sources but the company wants to encourage
internal purchases.
Variable cost transfer price with or without markup could be used when idle capacity exists because opportunity cost (C.M.) equal zero. Also fixed cost would be irrelevant
As a disadvantage of these models is the fact that it is not viewed favorably by tax authorities
because it lowers the profits, and thereby taxes, for the location where the product was manufactured (selling division).
If cost based transfer prices without markup is used, then the selling division will be treated as
a cost center rather than a profit center thus a sustained level of managerial effort may not be
maintained because selling division will earn no-return on internal sales which could lead to
suboptimization, especially if external market exists for the supplying division to sell its
products.
2- Full Cost (Absorption) Model
The transfer price could be based on full cost (actual or budgeted) or full cost plus markup (either an amount or %). Cost plus can be used when a market price is not available.
And if the profit markup is a percentage of cost rather than fixed amount, it actually gives the selling department an incentive to inflate the actual cost through production inefficiencies and excessive allocation of common costs.
The advantages of using full cost are that it is well understood, and the cost information is easily available in the accounting records. Because the product is transferred at cost, there is no need to eliminate intracompany profits from inventories in consolidated financial statements and income tax returns. Furthermore, the transferred cost can be easily used to compare actual and budgeted costs.However, because it includes fixed costs, it can be misleading and cause poor decision-making. It is not appropriate for decentralized companies that need to measure the profitability and performance of different profit centers. If full cost is used, the transfer price may well be higher than the buying department can get the item for by purchasing it outside. The buying department will prefer to go outside. However, the external price may be greater than the selling department’s variable cost for the item. Since the fixed cost will be the same whether the part is manufactured internally or purchased outside, the consolidated profit of the firm will be lower if the purchasing department buys the item outside.
Full cost transfer price, is the price set by an absorption costing calculation, it includes (D.M. + D.L. + Full allocation of manufacturing O.H.)
The full cost (absorption) model starts with the seller’s variable cost for the item and then allocates fixed costs to the price. Some companies allocate standard fixed costs because this allows the buying unit to know the cost in advance and keeps the seller from becoming too inefficient due to a captive (helpless) buyer that pays for the inefficiencies of the seller. Adding fixed costs is relatively straightforward and fair. However, it can alter a business unit’s decision making.
Although fixed costs should not be included in the decision to purchase items internally or
externally, often managers will purchase the “lower-cost” external item even though the internal
fixed costs will still be incurred which would lead to impairment of goal congruence.
The markup determined by top management to be added to either variable or full cost should be relatively objective in order to cause Goal Congruence if this markup is arbitrary % or amount it could result in suboptimization.
Note: Cost plus is what is generally used in government contracts in the US and cost accounting standard board was set up by the government to help determine what the cost of production is and what can be included in this calculation .
Disadvantages of Cost-based Transfer price with or without markup
- the most significant disadvantage of cost based transfer price is that it may not promote long-term efficiencies and it can lead to sub-optimal decisions for a company as a whole.
- Setting the transfer price based on actual costs (with or without markup) rather than standard costs would give the selling division little or no incentive to control costs thus inefficiencies of the selling division would be charged to the buying division.
- It may lead to charging more than the market price to transfer goods or services internally because cost based transfer prices ignores market price. Thus market effects on the company operations are considered irrelevant under these pricing approaches.
But advantages of cost based transfer prices, that it provides clarity and administrative convenience because top management can enter the decision process by determining the markup % or amount .
Arbitrary Pricing
Transfer prices may simply be set by central management to achieve tax minimization or some
other overall objective. The advantage to this method is that the price achieves the objectives that central management considers most important. The disadvantages far outweigh the advantages, however, because this method defeats the goal of making divisional managers profit conscious. It hampers their autonomy as well as their profit incentive.
When deciding which method to use, management will generally consider a number of factors. The most common factors are the following items:
- The goals of the company and what method will best enable those goals to be met (goal
Congruence), - Factors relating to the capacity of the producing department, its ability to sell the product on the open market and the ability of the purchasing department to buy the product on an open market.
Dual-pricing
Dual-pricing policy ⇒ is a management policy under which different prices recorded by the
buying and selling divisions. Dual-pricing policy motivates both divisions
Dual pricing is another method, in which the selling and the purchasing departments each
record the transaction at different prices. For example, the seller records it at market value, but
the purchasing department records it at variable cost of production. As a result of this, each
department’s results are more positive on paper. If this is done, the total of the divisional
profits will be greater than the profit for the company as a whole. The profit assigned to the
producing division will need to be eliminated when the consolidated financial statements and
income tax returns are prepared.
The advantage of this is that the selling division has an incentive to expand sales and
production; while at the same time, the buying division gets to book the product at its actual
cost to the firm. So the buying division’s costs do not include an artificial profit for the selling
division. Thus, variable cost is used for decision-making, but market price is used for
evaluation.
The main disadvantage of this system is that it is complex and there is difficulty inherent in
evaluating the relative performance of the selling and the buying divisions, because their
profits have been determined on different bases.