TRANSFER PRICING

IN DECENTRALIZED
ORGANIZATION
TRANSFER PRICING
The internal selling price used when goods and services are
transferred between one division to another division in the
decentralised organisation
CIMA defines transfer price as the price at which goods or
services are transferred between different units of the same
company
• Revenue for the supplying/selling unit and cost for the
receiving/buying unit
Transfer price allows
• the supplying unit to earn profit to reflect their effort in
producing the product
• The receiving unit to record the cost of the transfer of the
product which will match with the external market.
• Each unit to show profits for their efforts (in the situation where
there is a series of transfers of product between units)
 TRANSFER PRICING

The amount charged when one division

sells/supply goods or services to
another division

Batteries

Battery Division Auto Division

(supplying division) (receiving division)
 TRANSFER PRICING
The transfer price affects the profit measure for both the supplying
division and the receiving division.

A higher transfer
price for batteries
means . . .

greater
Battery Division profits for the Auto Division
(supplying division) battery division. (receiving division)
 TRANSFER PRICING
The transfer price affects the profit measure for both the supplying
division and the receiving division.

A higher transfer
price for batteries
means . . .

lower profits
Battery Division for the Auto Division
(supplying division) auto division. (receiving division)
 TRANSFER PRICING
• TP encourages each unit generate profits, so
encourage managers to manage their units as if it
were a stand-alone business.
• TP does not affect company’s profit, only external
revenue and external costs have implications on
overall company’s profits
• The transfer price should:
• Result in unit profits that are a reliable and
accurate measure of unit performance
• Preserve and encourage autonomy within units
• Encourage goal-congruent behaviour
OBJECTIVES OF TRANSFER PRICING
• Goal congruence
The ideal transfer price allows each division manager to make decisions that
maximize the company’s profit, while attempting to maximize his/her own
division’s profit.
• Allocating profit between divisions
Managers have to ensure the allocation of corporate profit is fairly distributed
among divisions to promotes motivational benefits for divisional
managers
• Basis for performance measurement
Divisional manager is evaluated on divisional profit thus divisional profit
measure is also used to also evaluate the performance of managers
• Minimizing global tax liability
If divisions are operating within single tax system, transfer pricing policy will
have little impact on corporate tax
• Retaining divisional autonomy
To retain divisional autonomy, decentralized divisions often set a transfer
pricing policy that is beneficial to both divisions and the company as
whole
TRANSFER PRICING METHODS
Transfer Pricing Methods:
• Market-based transfer price
• Cost-based transfer price
• Negotiated transfer price
• Dual pricing

(1) Market-based Transfer Price

• Is the price of the goods sold in an external market
• Need competitive external markets for a product where no
individual buyer or seller can influence the market
• For inter-divisional transfer, costs such as selling expenses are
avoided and thus the TP should be lower than normal market price
TRANSFER PRICING METHODS
(2) Cost-based Transfer Price
• 3 common types which are marginal cost transfer price, full cost
transfer price and cost plus a markup transfer price

• Marginal Cost Transfer Price – TP based on the variable costs

only thus buying division will pay lower price compare to price at
open market.

• Full Cost Transfer Price – TP is the sum of variable cost plus the
fixed cost . TP inclusive of irrelevant fixed costs which may lead to
sub-optimization of decisions. Furthermore, no profit will be reported
by the supplying division and may result to dysfunctional behaviour.

• Cost Plus Mark Up Transfer Price - allows supplying division to

earn a profit on inter-divisional transfer of goods or services
 TRANSFER PRICING METHODS
(3) Negotiated Transfer Price
• TP is set by a process of negotiation between divisions
• The managers of profit centers and investment centers may
negotiate the price at which transfers will be made.
• The external market price may form the starting point for
negotiations, and the incremental cost of producing and supplying
the product to the buying unit may form the lower bounds of the
transfer price.
• Much management time is used in the negotiation process.

(4) Dual Pricing

• It overcomes the problems of marginal cost-based pricing. Dual
pricing allows the divisions to set different prices. The supplying
division will use the price (i.e market price) that will allow a
reasonable profit to be reported in their books. In Receiving Division
book, the transfers will be charged at marginal cost.
 GENERAL-TRANSFER-PRICING RULE
• Provides guidance on the appropriate transfer price
• Represents a minimum transfer price
• May guide unit managers to make goal-congruent
decisions
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer + Supplying unit
price = incurred by
Supplying (contribution foregone by
Unit transferring the good
internally rather than
selling the goods
externally)
SCENARIO I: NO EXCESS CAPACITY

The Battery Division makes a standard 12-volt battery.

Production capacity 300,000 units
Selling price per battery RM40 (to outsiders)
Variable costs per battery RM18
Fixed costs per battery RM7 (at 300,000 units)
The Battery division is currently selling 300,000 batteries
to outsiders at RM40. The Auto Division can use 100,000
of these batteries in its X-7 model.

What is the appropriate transfer price?

 SCENARIO I: NO EXCESS CAPACITY

Opportunity cost
Transfer Variable costs
= + per unit to the
price Per unit
Battery Division
Of Supplying
because of
Division
the transfer
RM22 per
Transfer RM18 per battery
price = + battery
(RM40-RM18)
Contribution
Transfer lost
price = RM40 per battery
SCENARIO I: NO EXCESS CAPACITY

If Auto division can If Auto division can

purchase 100,000 purchase 100,000
batteries from an batteries from an
outside supplier outside supplier
for less than $40. for more than $40.

Transfer Transfer
will not $40 will
occur. transfer occur.
price
SCENARIO II: EXCESS CAPACITY

The Battery Division makes a standard 12-volt battery.

Production capacity 300,000 units

Selling price per battery RM40 (to outsiders)
Variable costs per battery RM18
Fixed costs per battery RM7 (at 300,000 units)

The Battery division is currently selling 150,000

batteries to outsiders at RM40. The Auto Division can use
100,000 of these batteries in its X-7 model. It can
purchase them for RM38 from an outside supplier.

What is the appropriate transfer price?

SCENARIO II: EXCESS CAPACITY

Transfer Variable Opportunity cost

price = cost per unit
+ per unit to the
organization
because of
Transfer the transfer
RM18 variable
price = cost per battery + RM0

Transfer = RM18 per battery

price
SCENARIO II: EXCESS CAPACITY

General Rule

When the selling division is operating

below capacity, the minimum transfer
price is the variable cost per unit.

So, the transfer price will be not lower

than RM18, and not higher than RM38
SCENARIO II: EXCESS CAPACITY

Transfer Transfer Transfer

will not will will not
occur occur occur

RM18 RM38
transfer transfer
price price
TRANSFER PRICING UNDER
DIFFERENT SCENARIOS
1. External market and spare capacity in the
supplying unit
• Where there is spare capacity the transfer
of product, gives the supplying unit
additional profits that it would not otherwise
have
• The two units may negotiate a transfer price
less than the market price to provide an
incentive for the buying unit to purchase
from the supplying unit
TRANSFER PRICING UNDER
DIFFERENT SCENARIOS
2. External market and no spare capacity in the
supplying unit
• When there is no spare capacity, the supplying unit will need to
take account of the opportunity cost of lost profits on sales due
to the transfer

3. External market and limited spare capacity in

the supplying unit
• Where capacity is limited, an opportunity cost needs to be
accounted for in the transfer price
TRANSFER PRICING UNDER
DIFFERENT SCENARIOS
4. No reliable external market and spare
capacity in the supplying unit
• There is no opportunity cost associated
with the transfer so the transfer price may
be based on cost-plus
5. No reliable external market and no spare
capacity in the supplying unit
• The transfer price will need to account for
opportunity cost on lost sales due to the
transfer
WHO SETS THE TRANSFER
PRICES?
• Managers of profit centres and investment centres may
have considerable autonomy in deciding whether
• to accept or reject orders for goods or services
• to source their materials inside or outside the organisation
• to set and accept transfer prices

• Direct intervention by corporate (head office) managers

to dictate specific transfer prices may be inconsistent
with the philosophy of decentralisation

• Corporate management may develop general policies

to govern transfer pricing practices
TRANSFER PRICING: THE INFLUENCE
OF INCOME TAXATION
Transfer pricing is used by many companies to
effectively ‘transfer profits’ between business
units in different countries
International transfer prices may be influenced by
the different taxation rates and different
regulations across countries
International tax considerations may influence the
transfer prices that are used for domestic
purposes
Service firms and not-for-profit organisations may
use transfer pricing when services are transferred
between business units
AN INTERNATIONAL
PERSPECTIVE
Since tax rates and import duties are different in
different countries, companies have incentives to set
transfer prices that will:
 Increase revenues in low-tax countries.
 Increase costs in high-tax countries.
 Reduce cost of goods transferred to high-
import-duty countries.
TRANSFER PRICING AND SERVICE
LEVEL AGREEMENTS
•Dual-rate transfer pricing uses 2 separate TP to price
each inter-division transaction.
•A service level agreement (SLA) is a contract between
two units within an organisation which
• establishes the nature of the service that will be provided
by one unit to the other
• outlines the responsibilities of each party
• outlines price, quality and timing of service delivery,
performance targets, problem-solving arrangements,
ways in which the agreement can be changed or
terminated
• The price of the service is a transfer price and can be
determined using methods similar to those used for the
transfer of goods