Session 17

Transfer Pricing

FOCUS
This session covers the following content from the ACCA Study Guide.

D. Performance Measurements and Control

5. Divisional performance and transfer pricing
a) Explain and illustrate the basis for setting a transfer price using variable
cost, full cost and the principles behind allowing for intermediate markets.
b) Explain how transfer prices can distort the performance assessment of
divisions and decisions made.

Session 17 Guidance
Understand that, although transfer pricing may appear to be a complicated topic, the opportunity cost
approach to transfer pricing is based on the following:
• The minimum transfer price is that which covers the marginal (variable) cost plus the opportunity
cost of making the goods or services to be transferred. This view is from the selling division's
perspective.
• The maximum transfer price acceptable to the buying division would be the lower of: the external
market price (if this exists) and the net revenue to the buying division of selling the ultimate product.
Net revenue means the final selling price minus the costs incurred in the buying division (s.2).
(continued on next page)
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VISUAL OVERVIEW
Objective: To describe and assess the effect of transfer prices on divisional performance
evaluation.

TRANSFER PRICING
• When Needed
• Objectives

OPPORTUNITY PRACTICAL
COST APPROACH APPROACHES
• Selling Division • Market Price
Method DUAL PRICING
Perspective
• Buying Division • Full Cost Plus
Perspective • Variable Cost
Plus
• Marginal Cost
• Incongruent
Goal Behaviour

Session 17 Guidance
Read the article "Transfer Pricing" by Ken Garret (October 2009).
Recognise the alternative presented by various practical approaches to determining selling and
buying prices, along with the advantages and disadvantages of each (s.3).
Understand the mechanics and advantages of dual pricing as an optimal transfer pricing
method (s.4).

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Session 17 • Transfer Pricing F5 Performance Management

1 Transfer Pricing

Transfer price—the price at which one division transfers goods or

services to another division within a company or from one subsidiary
to another within a group.

An earlier session described methods of setting prices for goods

and services between independent parties.
In divisionalised organisations, the output of one department
may form the input for another department. For the purpose of
preparing management accounts for the two departments, which
reflects the work performed by both divisions, a transfer pricing
system is required.

1.1 When Needed

< A transfer pricing policy is needed when:
 an organisation has been decentralised into divisions; and
 inter-divisional trading of goods or services occurs.
< Transfers between divisions must be recorded in monetary
terms as revenue for supplying divisions and costs for
receiving divisions.
< Transfer pricing is more than just a bookkeeping exercise.
It can have a large effect on the behaviour of divisional
managers.

1.2 Objectives of Transfer Pricing

1.2.1 Goal Congruence
< Transfer prices should encourage divisional managers to make *Senior management
decisions in the best interests of the organisation as a whole. must design a transfer
< Any divisionalised organisation runs a risk of dysfunctional pricing system which
decision-making. Where inter-divisional trading occurs, this encourages divisional
risk is particularly high. managers to make
good decisions.
< Achievement of goal congruence must be the primary
objective of a transfer pricing system.*

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F5 Performance Management Session 17 • Transfer Pricing

Illustration 1 Goal Congruence

ABC Consulting has offices in several major cities in Eastern Europe.

Sometimes consultants in one office work on projects for other
offices. The transfer price charged is $1,100 per day of consulting.
The managing director of the Kiev office of ABC Consulting
discovered that he could hire reliable consultants on a freelance basis
for $500 per day. On a recent project, in July, he used the services
of a local freelance consultant for five days, paying $2,500 in total.
"I've saved the Kiev office $3,000!" he declared triumphantly at the
end of the week.
During the week in question, the Moscow office of ABC Consulting
had a free consultant who could have done the work the freelance
consultant was hired to do. This consultant earns a fixed salary,
so the additional cost to the company of this consultant working
on the project in Kiev would have been a flight ticket of $500 and
accommodation of $500 in total.
The decision of the managing director of the Kiev office to hire the
freelance consultant cost ABC an additional $1,500 (the fee paid to
the freelance consultant of $2,500 less the savings on travel and
accommodation of $1,000).
This is an example of goal incongruence. The managing director of
the Kiev office made a decision that was good for the Kiev office,
but not good for the overall group. The reason for this was that the
internal transfer price was too high.

1.2.2 Divisional Autonomy

< Divisional managers should be free to make their own
decisions. A transfer pricing system should help eliminate the
head office telling divisions what to do.*

1.2.3 Divisional Performance Evaluation *Autonomy should

improve the motivation
< Transfer prices should be "fair" and allow an objective of divisional managers.
assessment of divisional performance.
< There is likely to be conflict between these objectives.

Goal congruence must take priority.

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Session 17 • Transfer Pricing F5 Performance Management

2 Opportunity Cost Approach

2.1 Supplying Division Perspective

< The selling division will accept a minimum transfer price equal
to:
Marginal (variable cost) + opportunity cost

< The opportunity cost is usually the lost contribution from

external sales, either of:
 the same product subject to the transfer price; or
 other products which the supplying division makes.

2.1.1 Scenario 1—Opportunity Cost Is Zero

When to use:

{ }
No external market No production
or and
External market but spare capacity constraints

In this situation, opportunity cost is zero because internal

transfers do not reduce contribution from external sales.

Example 1 No Opportunity Cost

Division Buy requires some components for its electronic games

console. Division Sell has some spare capacity and could make the
components for a variable cost of $60 each.
Required:
(a) Calculate the minimum transfer price acceptable to
Division Sell.
(b) State what will happen if Division Buy can buy externally
for $55.
(c) Conclude whether the actions of Division Buy and
Division Sell in part (b) lead to goal congruence.

Solution

(a) Minimum transfer price

(b) Externally price $55

(c) Conclusion

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F5 Performance Management Session 17 • Transfer Pricing

2.1.2 Scenario 2—Opportunity Cost Arises*

*An opportunity cost arises when an internal sale sacrifices an

external sale.

When used:

and
{ external market exists
supplying division at full capacity.

Example 2 With Opportunity Cost

Division Red makes Product Y and Product Z. The maximum capacity of the factory is 5,000
units per month in total. This capacity can be used to make either 5,000 units of Product Y or
5,000 units of Product Z, or any combination of the two.
Y Z
Selling price $12 $16
Variable cost $9 $11
Extra cost if sold externally $1 $1
Contribution $2 $4

Required:
(a) Determine which product Division Red would make, and what would be the
monthly contribution of the division.
(b) Division Blue has asked Division Red to supply 1,000 units of Product Y per
month. Determine the minimum transfer price which would be acceptable to
Division Red.
(c) Division Blue now informs Division Red that it can buy product Y from an
external supplier for $11 per unit and is not prepared to accept a price above this
from Division Red.
Explain what would happen if both divisions were given autonomy to make their
own decisions. Comment on whether this benefits the company as a whole.
Solution

(a) Division Red would make Product

The monthly contribution of the division would be

(b) The minimum transfer price acceptable to Division Red for Product Y is:

(c) Divisions are given autonomy—explanation and commentary.

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Session 17 • Transfer Pricing F5 Performance Management

2.2 Buying Division Perspective

< The maximum transfer price acceptable to the buying division
will be the lower of:
 the external market price (if an external market exists); or
 the net revenue of the buying division.
< The net revenue of the buying division means the ultimate
selling price of the goods/ services sold by the buying division,
less the cost of those goods incurred by the buying division.

Illustration 2 Maximum Transfer Price

The bottling division of a large soft drink manufacturer buys special syrup, made
according to a secret recipe, from the syrup division. The bottling division adds
carbonated water to the syrup to make the drink, then bottles the drink and sells it to
distributors.
Each bottle is sold for 50 cents. The bottling division has calculated that the costs of
making the drink and bottling it (excluding the cost of buying the syrup) are 20 cents
per bottle. The net revenue of the bottling division is therefore 30 cents per bottle.
If the syrup division were to propose a transfer price in excess of 30 cents per bottle for
the syrup, the bottling division would incur a loss.

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F5 Performance Management Session 17 • Transfer Pricing

Example 3 Alternative Transfer Prices

Division I is an intermediate division. It supplies a special chemical to division F, the final

division. Division I has spare capacity.
Output of the chemical is limited. Variable cost per kg is $500. No external market for the
chemical exists.
Division F processes the chemical into the final product. Each unit of the final product
requires 1 kg of the chemical. Demand for the final product exceeds production.
Selling price per unit of the final product is $1,000. The further processing cost per unit in
Division F is $200.
Required:
(a) Calculate the maximum price Division F will be prepared to pay for one kg of
the chemical.
(b) Calculate the minimum price Division I will accept for 1 kilo of the chemical.
(c) Comment on the performance evaluation issues if:
(i) a transfer price of $500 is used
(ii) a transfer price of $800 is used.
(d) Suggest an alternative transfer price which would lead to a fairer evaluation
of the performance of the two divisions.

Solution

(a) Maximum transfer price = Net revenue of buying division

$
Ultimate selling price
Further processing costs in Division F
Net revenue

(b) Minimum price acceptable to Division I

$

Minimum transfer price

(c) Performance evaluation

(d) Alternative transfer price

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Session 17 • Transfer Pricing F5 Performance Management

3 Practical Approaches

3.1 Market Price Method

< May be used if buying and selling divisions can buy/sell
externally at market price.
< However, the market price might need to be adjusted
downwards if internal sales incur lower costs than external
sales (e.g. due to lower delivery costs).
Advantages Disadvantages
Optimal for goal congruence Only possible if a perfectly
if the selling division is at competitive external market
full capacity. exists.
Encourages efficiency—the Market prices may fluctuate.
supplying division must
compete with external
competition.

3.2 Full Cost Plus

< The supplying division charges full absorption cost plus a
mark-up.
< Standard costs should be used rather than actual to avoid
selling divisions transferring inefficiencies to buying divisions.
Advantages Disadvantages
Easy to calculate if standard The fixed costs of the
costing system exists. selling division become the
Covers all costs of the variable costs of the buying
selling division. division—may lead to
dysfunctional decisions.
May approximate to market
price. If the selling division has
spare capacity it may lead
to dysfunctional decisions.
Mark-up is arbitrary.

3.3 Variable Cost Plus

< Similar to above—dysfunctional if spare capacity exists.
3.4 Marginal Cost
Marginal cost = variable cost + any incremental fixed costs e.g. stepped costs

Advantage Disadvantage
Optimal for goal congruence May be difficult to calculate
when: (variable cost is often used
 the selling division has as an approximation).
spare capacity; or
 no external market
exists.

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F5 Performance Management Session 17 • Transfer Pricing

3.5 Incongruent Goal Behaviour

All the practical approaches suffer from the potential problem
that the transfer price may lead to behaviour which is not
congruent with overall firm goals. The selling division may
set a price too high for the buying division, leading the buying
division to buy externally or forgo production.

Illustration 3 Incongruent Behaviour

A selling division has spare capacity. It produces Product B, which

has a marginal cost of $10 per unit.
Another division within the company used Product B in its
production. The selling division can provide all of the supplies
required by the buying division within its spare capacity. The buying
division can also obtain supplies of Product B externally for $15 per
unit.
If a transfer price is set higher than $15 per unit using any of the
practical methods described above, then the buying division will buy
externally.
This leads to an extra cost to the company overall of $5 per unit of
product B because Product B could be produced internally by the
selling division for $10 per unit.

4 Dual Pricing
Dual pricing is sometimes used in situations where there is no
transfer price which would be acceptable to both the buying
division and the selling division, so in the absence of intervention
by the head office, the two divisions would not trade with each
other.
The head office may wish both divisions to trade for non-financial
reasons and may therefore use a system of dual pricing to
encourage them to do so.
Dual pricing works as follows:
< A higher price is used when calculating the revenue of the
selling division for goods supplied to the buying division.
< A lower price is used when calculating the costs in the selling
division for the goods supplied to it by the selling division.
< The head office absorbs the difference between the two as a
head office overhead.

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 Summary
< Transfer pricing occurs between a selling division and a buying division in the same
company, or among subsidiaries in the same group. Transfer pricing can affect divisional
managers' behaviour.
< Appropriate transfer pricing aligns divisional goals with an organisation's strategic objectives
while allowing an objective assessment of divisional performance.
< A division with no external market or ample spare capacity has zero opportunity cost
because transfers do not reduce contribution from external sales. Its marginal cost would
serve as an appropriate transfer price.
< A division with an external market or no spare capacity would lose external sales by an
internal transfer. Its marginal cost plus the lost contribution would serve as an appropriate
transfer price.
< Practical approaches all suffer from the potential problem of incongruent divisional and
overall corporate goals.
• Market price method optimises overall corporate objectives when a selling division oper-
ates at full capacity and has an external market.
• Full cost plus method uses standard costs plus a mark-up, but mark-up is arbitrary and
the method may lead to dysfunctional decisions where spare capacity exists.
• Variable cost plus is similar but uses standard variable rather than full costs. It is not
suitable when fixed costs represent a high proportion of total costs.
• Marginal costs (variable plus incremental fixed costs) represent an optimal outcome
for the overall company where no external market exists or the selling division has
spare capacity.
< Dual pricing solves the problem of goal incongruence as the head office absorbs the
difference in prices charged by the selling division and paid by the buying division while still
allowing appropriate assessment of each division manager's performance.

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 Session 17

Session 17 Quiz
Estimated time: 15 minutes

1. List THREE goals of transfer pricing. (1.2)

2. Discuss TWO scenarios for transfer pricing from the supply division perspective. (2.1)
3. Describe the advantages and disadvantages of the market price method of transfer
pricing. (3.1)
4. State the purpose of using standard variable or full costs rather than actual costs in a transfer
pricing scheme. (3.2, 3.3)
5. Describe dual pricing and why it presents an optimal alternative to other transfer pricing
schemes. (4)

Study Question Bank

Estimated time: 100 minutes

Priority Estimated Time Mastery

MCQs – Session 17 20 minutes

Q38 Musent 40 minutes

Q39 Able & Baker 40 minutes

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EXAMPLE SOLUTIONS
Solution 1—No Opportunity Cost
(a) Minimum transfer price = marginal cost + Opportunity Cost =
$60 + $0 = $60.
Opportunity cost is $0 because the 500 units needed could be
produced within the spare capacity of Division Sell.
(b) External price $55
Division Buy will buy externally. No transfer takes place.
(c) Conclusion
Both divisions are acting in the company's overall best interests.
By buying externally for $55, Division Buy is saving the company
$5 per component, since the cost to the company of making the
components is $60.

Solution 2—With Opportunity Cost

(a) Division Red would clearly make Product Z, as this generates the
highest contribution per unit. Total contribution would therefore
be $20,000 per month ($5,000 x 4).
(b) The minimum transfer price acceptable to Division Red for
Product Y is:

$
Marginal (variable) cost 9
Opportunity cost 4
Minimum transfer price 13

The opportunity cost is the lost contribution per unit from selling
Product Z.
(c) Division Red would refuse to sell for less than $13, so Division
Blue would buy externally for $11 per unit.
Both divisions are acting in a way which is good for the
organisation as a whole. Although the variable cost to the
company of making Product Y is only $9, the opportunity cost of
$4 is a real cost.
The cost to Division Red of producing Product Y, and therefore
the cost to the company as a whole, is $13 per unit. By buying
externally for $11, Division Blue is saving the company $2 per
unit.

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Solution 3—Alternative Transfer Prices
(a) Maximum transfer price to Division F = Net revenue

$
Selling price 1,000
Further processing costs in
Division F (200)
Net revenue 800

The net revenue of $800 per kilo represents the maximum

that Division F would be prepared to pay to Division I for the
chemical. If the price exceeds this, then Division F will incur a
loss.
(b) Minimum price acceptable to Division I

$
Marginal (variable) cost per kilo 500
Opportunity cost 0
Minimum transfer price 500

(c) Performance evaluation

(i) If the minimum transfer price of $500 is used, then
Division I will make no profit.
(ii) If the maximum transfer price of $800 is used, then Division F
makes no profit.
(d) Alternative transfer price
Any transfer price between $500 and $800 per kilo should be
acceptable to both parties. Without any further information
about the nature of the production process and how much effort
is made by the two divisions, it is difficult to make a judgement
about what would be a "fair" transfer price.
One suggestion might be to set a transfer price that is the mid-
point between the minimum and the maximum. This would be a
price of $650 per kilo. If this were the case, both divisions could
share the profits equally.

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