ADVANCED MANAGEMENT ACCOUNTING

“TRANSFER PRICING IN DIVISIONALIZED COMPANIES”

BY:
GROUPS 3

Putu Tiya Kirana Wibawa (15 / 2381611065)

I Dewa Ayu Adnyaswari (16 / 2381611066)
Ni Wayan Dina Sumantari (17 / 2381611067)

MASTER OF ACCOUNTING
FACULTY OF ECONOMICS AND BUSINESS
UDAYANA UNIVERSITY
2023
I. PURPOSE OF TRANSFER PRICING
A transfer pricing system can be used to meet the following purposes:
1. To provide information that motivates divisional managers to make good economic
decisions. This will happen when actions that divisional managers take to improve the
reported profit of their divisions also improves the profit of the company as a whole.
2. To provide information that is useful for evaluating the managerial and economic
performance of the divisions.
3. To ensure that divisional autonomy is not undermined.
4. To intentionally move profits between divisions or locations for shifting taxable profits
to divisions located in different countries
The Description
1) Providing information for making good economic decisions
Goods transferred from a supplying division to a receiving division are known as
intermediate products. The products sold by a receiving division to the outside world are
known as final products. The objective of the receiving division is to subject the intermediate
product to further processing before it is sold as a final product in the outside market. The
transfer price of the intermediate product represents a cost to the receiving division and a
revenue to the supplying division. Therefore transfer prices are used to determine how much
of the intermediate product will be produced by the supplying division and how much will be
acquired by the receiving division.
2) Evaluating divisional performance
When goods are transferred from one division to another, the transfer price represents
revenue to the supplying division and a cost to the receiving division. It therefore moves
reported profit between divisions. Consequently, the prices at which goods are transferred
can influence each division’s reported profits, and there is a danger that an unsound transfer
price will result in a misleading performance measure that may cause divisional managers to
believe that the transfer price is affecting their performance unfairly.
3) Conflict of objectives
Unfortunately, no single transfer price is likely to perfectly serve all of the specified
purposes. They often conflict and managers are forced to make trade-offs. In particular, and
importantly, the decision making and the performance evaluation purposes may conflict with
one another. For example, in some situations, the transfer price that motivates the short-run
optimal economic decision is incremental cost. If the supplying division in our earlier

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example has excess capacity, the incremental cost will probably equal variable cost. In this
case the supplying division will fail to cover any of its fixed costs when transfers are made at
variable cost, and will therefore report a loss.

II. ALTERNATIVE TRANSFER PRICING METHODS

The management accounting literature identifies many different types of transfer price
that companies can use to transfer goods and services. The most notable ones are:
1) MARKET-BASED TRANSFER PRICES
In most circumstances, theoretically, where a perfectly competitive market for an
intermediate product exists, it is optimal for both decision-making and performance
evaluation purposes to set transfer prices at competitive market prices. A perfectly
competitive market exists in which products sold are identical and no individual buyer or
seller can affect the market prices. When transfers are recorded at market prices, divisional
performance is more likely to represent the real economic contribution of the division to total
company profits. If the supplying division did not exist, the intermediate product would have
to be purchased on the outside market at the current market price. Alternatively, if the
receiving division did not exist, the intermediate product would have to be sold on the
outside market at the current market price. Divisional profits are therefore likely to be similar
to the profits that would be calculated if the divisions were separate organizations.
Consequently, divisional profitability can be compared directly with the profitability of
similar companies operating in the same type of business.
2) COST PLUS A MARK-UP TRANSFER PRICE
This exhibit shows the profit for the Baltic Group as a whole using the data given in
Example 20.1. For convenience this is presented in batches of 1,000 units at each selling
price. The profit-maximizing output is 5,000 units. The aim of the transfer pricing system
should be to motivate both the supplying division (Oslo) and the receiving division (Bergen)
to operate at the optimum output level of 5,000 units. Assuming that the cost base for the cost
plus a mark-up transfer price is full cost, the fixed costs of the supplying division will be
unitized by dividing the fixed costs of £60,000 for the period by the estimated output. The
resulting unitized fixed cost will be added to the unit variable cost to derive a full cost per
unit of output. A profit mark-up is then added to full cost to derive the transfer price.

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Let us assume that £35 per unit (or £35,000 per 1,000 units) is the full cost plus a mark-up
transfer price based on a unit fixed cost of £12 derived from dividing £60,000 fixed costs by
an estimated output of 5,000 units plus a unit variable cost of £11 plus a mark-up of £12. At
this transfer price the profit computations for each division will be as follows: Oslo division
(Supplying division).

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 The supplying division maximizes profits at an output level of 6,000 units whereas the
receiving division maximizes profits at 3,000 units, so neither division will be motivated to
operate at the optimal output level for the company as a whole of 5,000 units. The receiving
division will therefore choose to purchase 3,000 units from the supplying division. This is
because the Bergen division will compare its net marginal revenue with the transfer price and
expand output as long as the net marginal revenue of the additional output exceeds the
transfer price. Note that net marginal revenue is defined as the marginal (incremental)
revenue from the sale of an extra unit (or a specified number of incremental units) of the final
product less the marginal/incremental conversion costs (excluding the transfer price). The
calculations of net marginal revenues are as follows for increments of 1,000 units:

If you refer to the receiving division (Bergen) in the schedule of profit calculations, you
will see that expanding output from 1,000 to 2,000 units results in total revenues increasing
from £100,000 to £180,000, so the marginal revenue is £80,000. Also variable conversion
costs increase from £7,000 to £14,000, so marginal cost is £7,000. Therefore net marginal
revenue is £73,000 (£80,000 2 £7,000). Faced with a transfer price of £35,000 per 1,000
units, the Bergen division will not expand output beyond 3,000 units because the transfer
price paid for each batch (£35,000) exceeds the net marginal revenue. The manager of the
Bergen division views the £35 per unit as a totally variable cost to his/ her division, whereas
it actually consists of both variable and fixed costs in the whole company analysis. This
inevitably leads to different volume decisions.
3) MARGINAL/VARIABLE COST TRANSFER PRICES
Marginal cost is a term that is used by economists. It refers to the additional cost of one
extra unit of output. Accountants generally assume that marginal cost is the same as variable
cost. When the market for the intermediate product is imperfect or non-existent, transfer
prices set at the variable/marginal cost of the supplying division can motivate both the
supplying and receiving division managers to operate at output levels that will maximize
overall company profits. Setting the transfer price at the unit variable cost of the supplying
division will motivate the divisional managers to operate at the optimum output level for the
company as a whole, provided that the supplying division manager is instructed to meet the

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demand of the receiving division at this transfer price. Although the variable cost transfer
price encourages overall company optimality, it is a poor measure of divisional performance.
4) FULL COST TRANSFER PRICES WITHOUT A MARK-UP
It was pointed out that full costs require that predetermined fixed overhead rates should
be established. Let us assume that the 5,000 units optimal output level for the company as a
whole is used to determine the fixed overhead rate per unit. Therefore the fixed cost per unit
for the intermediate product will be £12 per unit (£60,000 fixed costs/5,000 units) giving a
full cost of £23 (£11 variable cost plus £12 fixed cost). If the transfer price is set at £23 per
unit (i.e. £23,000 per 1,000 batch) the receiving division manager will expand output as long
as net marginal revenue exceeds the transfer price. If you refer to the net marginal revenue
schedule shown in the section describing cost plus a mark-up transfer price, you will see that
the receiving division manager will choose to purchase 4,000 units. Therefore the supplying
division will report a loss because all of its fixed costs have not been recovered. Hence the
transfer price is suitable for neither performance evaluation nor ensuring that optimal output
decisions are made.
5) NEGOTIATED TRANSFER PRICES
The difficulties encountered in establishing a sound system of transfer pricing have led
to suggestions that negotiated transfer prices should be used. Negotiated transfer prices are
most appropriate in situations where some market imperfections exist for the intermediate
product, such as where there are several different market prices. When there are such
imperfections in the market, the respective divisional managers must have the freedom to buy
and sell outside the company to enable them to engage in a bargaining process. It is claimed
that if this is the case then the friction and bad feeling that may arise from a centrally
controlled market transfer price will be eliminated without incurring a misallocation of
resources.
6) MARGINAL/VARIABLE COST PLUS OPPORTUNITY COST TRANSFER
PRICES
Setting transfer prices at the marginal/variable cost of the supplying division per unit
transferred plus the opportunity cost per unit of the supplying division is often cited as a
general rule that should lead to optimum decisions for the company as a whole. Opportunity
cost is defined as the contribution foregone by the supplying division from transferring
internally the intermediate product. This rule will result in the transfer price being set at the
variable cost per unit when there is no market for the intermediate product. You should have
noted that applying the above general rule leads to the same transfer price as was

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recommended earlier in this chapter.
In other words, if there is a perfectly competitive external market for the intermediate
product, the market price is the optimal transfer price. When there is no market for the
intermediate product, transfers should be made at the variable cost per unit of output of the
intermediate product. Thus, the general rule is merely a restatement of the principles that
have been established earlier. The major problem with this general rule is that it is difficult to
apply in more complex situations such as when there is an imperfect market for the
intermediate product. Note also that the analysis within this chapter is based on single
product examples. In a large and dynamic business there may be multiple products and
divisions all requiring detailed attention, so in practice it becomes much more complex to
analyse.

III. COMPARISON OF COST-BASED TRANSFER PRICING METHODS

Note that it is assumed that there is no market for the intermediate product. You will see
that the variable (marginal) cost of the intermediate product is assumed to be constant
throughout the entire production range and that the net marginal revenue for the final product
declines to reflect the fact that to sell more the price must be lowered. Remember it was
pointed out earlier that the term ‘net marginal revenue’ refers to the marginal revenue of the
final product less the marginal/variable conversion costs (excluding the transfer price)
incurred by the receiving division.

Economic theory indicates that the optimal output for the company as a whole is where
the marginal cost of producing the intermediate product is equal to the net marginal revenue
from the sale of the final product. If the transfer price is set at the variable cost per unit of the
intermediate product, the receiving division will purchase the intermediate product up to the
point where net marginal revenue equals its marginal/ variable costs. It will therefore result
in the optimal output from the overall company perspective (Q2). If a higher transfer price is

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set (as indicated by the green line) to cover full cost, or a mark-up is added to full cost, then
the supplying division will restrict output to suboptimal levels such as Q1. Transfer pricing
becomes even more complex when we introduce an imperfect market for the intermediate
product. You should note, however, that where there is an imperfect market for the
intermediate product the theoretically correct transfer price is still the variable/marginal cost
of producing the intermediate product at the optimal output for the company as a whole.

IV. PROPOSALS FOR RESOLVING TRANSFER PRICING CONFLICTS

Our discussion so far has indicated that in the absence of a perfect market for the
intermediate product, none of the transfer pricing methods can perfectly meet both the
decision-making and performance evaluation requirements, and also not undermine
divisional autonomy. entral headquarters intervention may be necessary to instruct the
supplying division to meet the receiving division’s demand at the marginal cost of the
transfers. Thus, divisional autonomy will be undermined. Transferring at cost plus a mark-up
creates the opposite conflict. Here the transfer price meets the performance evaluation
requirement but will not induce managers to make optimal decisions. To resolve the above
conflicts the following transfer pricing methods have been suggested:
1) Adopt a dual-rate transfer pricing system.
Dual-rate transfer pricing uses two separate transfer prices to price each interdivisional
transaction. For example, the supplying division may receive the full cost plus a mark-up on
each transaction and the receiving division may be charged at the marginal (variable) cost of
the transfers.
2) Transfer at a marginal cost plus a fixed lump-sum fee.
A solution that has been proposed where the market for the intermediate product is
imperfect or non existent, and where the supplying division has no capacity constraints, is to
price all transfers at the short run marginal cost (assumed to be equivalent to variable cost per
unit of output) and for the supplying division to also charge the receiving division a fixed fee
for the privilege of obtaining these transfers at short-run variable cost. This approach is
sometimes described as a two-part transfer pricing system.

V. DOMESTIC TRANSFER PRICING RECOMMENDATIONS

This chapter has described the various approaches that can be adopted to arrive at
transfer prices for transactions between different units within an organization and the
circumstances in which they are appropriate. The following is a summary of the

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recommendations that can be derived from our discussion of the different transfer pricing
methods:

1. Where a competitive market exists for the intermediate product, the market price (less
any adjustments to reflect additional selling and distribution and collection expenses to
outside customers) should be used as the transfer price.
2. Where no external market exists for the intermediate product, transfers should be made
at the long-run marginal cost of producing a product or delivering a service. The long-
run marginal cost should consist of two elements – the variable cost per unit of the
product or service transferred and a fixed lump-sum fee based on the receiving division’s
budgeted use of theverage capacity of the supplying division.
3. Where an imperfect market for the intermediate product or service exists and a small
number of products or transactions are involved, a negotiated transfer pricing system is
likely to be the most suitable method. Here some form of external benchmark price is
likely to be available to enable a meaningful bargaining process to take place between
the supplying and receiving divisional managers.
4. Where cost-based transfer prices are used, standard costs and not actual costs per unit of
output should be used. If actual costs are used the supplying divisions will be able to
pass on the cost of any inefficiencies to the receiving divisions. Using standard costs
ensures that the cost of inefficiencies are borne by the supplying divisions.

VI. INTERNATIONAL TRANSFER PRICING

So far we have concentrated on domestic transfer pricing. International transfer pricing
is concerned with the prices that an organization uses to transfer products between divisions
in different countries. The rise of multinational organizations introduces additional issues that
must be considered when setting transfer prices. Taxation authorities in each country are
aware that companies can use the transfer pricing system to manipulate the taxable profits
that are declared in different countries and investigate the transfer pricing mechanisms of
companies to ensure that they are not using the transfer pricing system to avoid paying local
taxes. In an attempt to provide a worldwide consensus on the pricing of international
intrafirm transactions, the OECD issues guideline statements. The arm’s-length principle can
be implemented using one of the following methods:
1. The comparable uncontrolled price method (which uses externally verified prices of
similar transactions involving unrelated parties);

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2. The resale price method (which deducts a percentage from the selling price from the
final product to allow for profit);
3. The cost-plus method.

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 BIBLIOGRAFI
Collin kering, (2021). Pengelolaan Dan Biaya Akuntansi . hamshire: keterlibatan
Belajar Pers Bisnis.

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