1.3.1.

7 Rational and need for transfer price

price charged by one segment for a product/service that it supplies to another segment
used to determine the cost to charge another division, subsidiary, or segment
Transfer Price typically reflective of the market price for that good or service
Sales to Other Division --> use transfer price
both are valid sales for INTERNAL REPORTING purposes
Sales to Outsiders ---------> use market price
Since many companies today are giant conglomerates, with multiple divisions, simply transferring goods and services at cost no longer serve the needs of
Rationale
these decentralized organizations, which is to earn profit even through intercompany transactions for the purpose of performance evaluation.
Objectives of TP 1️⃣Goal Congruence, 2️⃣ Motivation, 3️⃣ Autonomy
price at which goods / services are sold in the open market
(1) Market-based TP best basis for transfer pricing
works best if selling division has NO idle capacity
can be either:
Variable Cost TP based only on VC or differential costs
Transfer Pricing
Schemes Full Cost TP also includes FOH and portions of marketing and admin costs.
(2) Cost-based TP
Full Absorption TP uses absorption costing - DM, DL, VOH and FOH
generally apply a normal markup on cost as a substitute for market prices when they are not
Cost-plus TP
immediately available.
(3) Negotiated TP agreed transfer price between divisions without basing it on market prices.
(4) Dual TP selling and buying divisions "record" for internal purposes different prices for the same product / service
🔷If LESS THAN full capacity:
VC per unit or differential cost per unit
❗Minimum Transfer Price should be EQUAL or 🔷If AT FULL CAPACITY:
(for selling division) GREATER THAN MIN. TP FORMULA #1: Differential cost per unit + lost CM per unit on external sales or opportunity
General Rules on
cost per unit
Transfer Pricing
MIN. TP FORMULA #2: VC per unit + (Total CM of lost external sales/Total units transferred)
❗Maximum Transfer Price should be EQUAL or
lowest external market price
(for buying division) LESS THAN
❗Transfer Pricing Range any amount between the minimum and maximum stated above
lower than average market prices which happens when supply outstrips demand
Distress Prices usually difficult to determine since market price of some commodities may stay at a "temporary distress price" for many years
manager of the selling division should not go beyond the distress price as long as it is still higher than the minimum transfer price.
Example 1 (Minimum and Maximum TP, Goal Congruence)
Data for Production Department of PASSER
Company with regards to its product PAPASAKA is
as follows: ANSWERS:
(1) a. Minimum TP = VC per unit since the selling division has sufficient idle
SP to outside market 40
capacity
VC per unit (VOH+VSAE) 21 Minimum TP = 21

FC per unit based on normal capacity 9 b. Maximum TP = lowest external market price
Capacity in units 60,000 Maximum TP = 38

c. Since the lowest acceptable TP for the selling division is 21 and the highest
Buying division is currently purchasing PAPASAKA from an outside supplier at acceptable TP of the buying division is 38, the transfer price can be at any amount
a cost of 38 and is considering purchasing 10,000 units of this product from between 21 and 38. Therefore, their managers can agree with the Transfer Price
the Production Department.
1. If selling division (Production Dept.) is currently operating at 50,000 units: d. The transfer can take place between the buying and selling division as far as
the whole company is concerned since the Transfer Price can be at 38 or below. It
a. How much is the Minimum TP would also be more beneficial for the transfer to take place due to the
consideration of the product's quality control when produced inside instead of
b. How much is the Maximum TP
being purchased from an outside supplier.
c. Will the managers of both the buying and selling division agree with the
Transfer Price?
(2) a. Minimum TP = VC per unit + Total CM on lost external sales/total units
d. Should the transfer take place from the standpoint of the whole company?
transferred
Minimum TP = 21 + [(40-21)x10000]/10000) = 40
2. Same questions as above except that it is at full capacity and sells the
product to outsiders. b. Maximum TP that buying division is willing to pay is still at 38

c. The minimum TP that the selling division can accept is 40 but the buying
division can only accept a maximum of 38. Therefore an agreement between them
3. Same questions as #1 except that Production has only an idle capacity of
is highly UNLIKELY
5,000 units and therefore must sacrifice 5,000 units of external sales to cover
the total units needed by buying division d. Transfer should not take place since the company as a whole will incur a loss of
2 per unit

(3) a. Minimum TP = 21 + [(40-21)x5000]/10000 = 30.50

b. Maximum TP that buying division is willing to pay is still at 38
c. Since the lowest acceptable TP for the selling division is 30.50 and the highest acceptable TP of the buying division is 38, the transfer price can be at any amount between 30.50
and 38. Therefore, their managers can agree with the Transfer Price
d. The transfer can take place between the buying and selling division as far as the whole company is concerned since the Transfer Price can be at 38 or below. It would also be
more beneficial for the transfer to take place due to the consideration of the product's quality control when produced inside instead of being purchased from an outside supplier.
Example 2 (Transfer Pricing Schemes)
Assume that CPABYMAY2024 Company's Sales Division is selling products to outside market at 350 per unit.
The company acquired a new division and this division is in need of the product that the Sales Division is selling.
This new division, before its acquisition, can purchase this product from another supplier at 350 less 10% discount.

Costs for Sales Division is as follows:

1. Differential cost = appropriate to guide top management in deciding whether there should be
DM 100 DM + DL + Var Costs 265 transfers between divisions as long as it is below external market prices
appropriate if both divisions are treated as cost centers rather than autonomous
DL 115 2. Full absorption cost 295 profit centers
Price that the new division pays to its independent supplier , appropriate if both
Variable OH 50 3. Market-based 315 divisions are treated as independent units
Fixed OH per unit
4. Full-cost plus The price that the company charges to its customers. Not appropriate since it
based on normal 30 markup 350 exceeds the amount that the new division is paying to its independent supplier
capacity
How much is the transfer price under different TP Appropriate if both divisions are treated as profit centers and they share in the
5. Negotiated Example:290 benefits
schemes?