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© 2015 McGraw‐Hill Education Garrison, Noreen, Brewer, Cheng & Yuen

Transfer Pricing

Appendix 13A

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Key Concepts/Definitions
A transfer price is the price
charged when one segment of
a company provides goods or
services to another segment of
the company.

The fundamental objective in

setting transfer prices is to
motivate managers to act in the
best interests of the overall
company.

© 2015 McGraw‐Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 98

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Three Primary Approaches

There are three primary

approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.

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Learning Objective 6

Determine the range, if any,

within which a negotiated
transfer price should fall.

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Negotiated Transfer Prices

A negotiated transfer price results from discussions

between the selling and buying divisions.
Range of Acceptable
Transfer Prices
Advantages of negotiated transfer prices:
Upper limit is
1. They preserve the autonomy of the determined by the
buying division.
divisions, which is consistent with
the spirit of decentralization.
2. The managers negotiating the
transfer price are likely to have much
better information about the potential
costs and benefits of the transfer
than others in the company. Lower limit is
determined by the
selling division.

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Grocery Storehouse – An Example

Assume the information as shown with

respect to West Coast Plantations and Grocery
Mart (both companies are owned by Grocery
Storehouse).

West Coast Plantations:

Naval orange harvest capactiy per month 10,000 crates
Variable cost per crate of naval oranges $ 10 per crate
Fixed costs per month $ 100,000
Selling price of navel oranges on the outside
market $ 25 per crate
Grocery Mart:
Purchase price of current naval oranges $ 20 per crate
Monthly sales of naval oranges 1,000 crates

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Grocery Storehouse – An Example

The selling division’s (West Coast Plantations) lowest acceptable transfer
price is calculated as:
Variable cost Total contribution margin on lost sales
Transfer Price  +
per unit Number of units transferred

Let’s calculate the lowest and highest acceptable

transfer prices under three scenarios.
The buying division’s (Grocery Mart) highest acceptable transfer price is
calculated as:
Transfer Price  Cost of buying from outside supplier
If an outside supplier does not exist, the highest acceptable transfer price
is calculated as:
Transfer Price  Profit to be earned per unit sold (not including the transfer price)

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Grocery Storehouse – An Example

If West Coast Plantations has sufficient idle capacity (3,000 crates) to
satisfy Grocery Mart’s demands (1,000 crates), without sacrificing
sales to other customers, then the lowest and highest possible
transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
$ -
Transfer Price  $10 + = $ 10
1,000
Buying division’s highest possible transfer price:
Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable

transfer prices is $10 – $20.
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Grocery Storehouse – An Example

If West Coast Plantations has no idle capacity (0 crates) and must
sacrifice other customer orders (1,000 crates) to meet Grocery Mart’s
demands (1,000 crates), then the lowest and highest possible transfer
prices are computed as follows:
Selling division’s lowest possible transfer price:
( $25 - $10) × 1,000
Transfer Price  $ 10 + = $ 25
1,000

Buying division’s highest possible transfer price:

Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, there is no range of

acceptable transfer prices.
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Grocery Storehouse – An Example

If West Coast Plantations has some idle capacity (500 crates) and
must sacrifice other customer orders (500 crates) to meet Grocery
Mart’s demands (1,000 crates), then the lowest and highest possible
transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
( $25 - $10) × 500
Transfer Price  $ 10 + = $ 17.50
1,000

Buying division’s highest possible transfer price:

Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable

transfer prices is $17.50 – $20.00.
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Evaluation of Negotiated Transfer Prices

If a transfer within a company would result in
higher overall profits for the company, there is
always a range of transfer prices within which
both the selling and buying divisions would have
higher profits if they agree to the transfer.

If managers are pitted against each other rather

than against their past performance or
reasonable benchmarks, a non-cooperative
atmosphere is almost guaranteed.

Given the disputes that often accompany the

negotiation process, most companies rely on
some other means of setting transfer prices.

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Transfers at the Cost to the Selling Division

Many companies set transfer prices at either

the variable cost or full (absorption) cost
incurred by the selling division.
Drawbacks of this approach include:
1. Using full cost as a transfer price
can lead to sub-optimization.
2. The selling division will never
show a profit on any internal
transfer.
3. Cost-based transfer prices do not
provide incentives to control
costs.

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Transfers at Market Price

A market price (i.e., the price charged for an

item on the open market) is often regarded as
the best approach to the transfer pricing
problem.
1. A market price approach works
best when the product or service
is sold in its present form to
outside customers and the
selling division has no idle
capacity.
2. A market price approach does
not work well when the selling
division has idle capacity.

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Divisional Autonomy and Suboptimization

The principles of
decentralization suggest
that companies should
grant managers autonomy
to set transfer prices and
to decide whether to sell
internally or externally,
even if this may
occasionally result in
suboptimal decisions.
This way top management
allows subordinates to
control their own destiny.
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End of Chapter 13

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