TRANSFER PRICING
The output of one division or segment can be used as an input for another segment or division.
A transfer price is the price charged when one segment of a company provides goods or services
to another segment of the company.
To the segment or department selling goods and services, the transfer price is its revenue. To the
segment or department buying the goods and services, the transfer price is its cost.
Impact of Transfer Price on Each Segment and the Company as a whole:
Segment X (seller) Segment Z (buyer)
Produces component and transfers it to Purchases component from Segment X at a
Segment Z for a transfer price of P50 per unit transfer price of P50 per unit
Transfer price = P50 per unit Transfer price = P50 per unit
Increases segment income Decreases segment income
Increases ROI Decreases ROI
Transfer price revenue = Transfer price cost
ZERO impact on the overall operation of the Company as a whole.
Based on the illustration above, it is normal for Segment X to want a higher transfer price as
possible to increase its income. Conversely, Segment Z would prefer a lower transfer price to
lessen its cost. For the company as a whole, X’s revenue minus Z’s cost equals zero.
However, divisions or segments may set transfer prices that maximize divisional profits but
lower firmwide profits. For example, suppose that Segment X sets transfer price of P50 for a
component that costs P40 to produce. If Segment Z can obtain the component from an outside
supplier for P47, it will refuse to buy from Segment X. Segment Z will realize a savings of P3
per component (P50 internal transfer price – P47 external price). If Segment X, however, cannot
replace the internal sales with external sales, the company as a whole will be worse off by P7 per
component (P47 external cost – P40 internal cost). This outcome would increase the total cost to
the firm as a whole!
Setting Transfer Prices
A transfer pricing system should satisfy three objectives: accurate performance evaluation, goal
congruence, and preservation of divisional autonomy. Accurate performance evaluation means
that no one divisional or segment manager should benefit at the expense of another (in the sense
that one division is made better off while the other is made worse off). Goal congruence means
that divisional managers should select actions beneficial to their segments as well as to the
company as a whole – there must be correspondence or consistency on the manager’s subgoals
Page 1 of 3
with the company’s overall goals. Autonomy means that top management should not interfere
with the decision-making freedom of divisional managers.
It is important to identify the minimum transfer price that a selling division would be willing to
accept and the maximum transfer price that the buying division would be willing to pay. These
minimum and maximum transfer prices correspond to the opportunity costs of transferring
internally within a bargaining range:
1. The minimum transfer price, or floor price, is the transfer price that would leave the
selling division no worse off if the goods are sold to an internal division, noting that the
selling division would prefer a higher price; however, the minimum transfer price is the
absolute lowest that could be accepted. In other words, it should not be less than the sum
of the selling segment’s incremental costs associated with the goods or services plus the
opportunity cost of the facilities used.
2. The maximum transfer price, or ceiling price, is the transfer price that would leave the
buying division no worse off if an input is purchased from an internal division, noting
that the buying division would prefer a lower price; however, the maximum transfer price
is the absolute highest that could be accepted. In other words, it should not be higher than
the lowest market price at which the buying segment can acquire the goods or services
externally.
The Minimum Transfer Price is equal to:
Minimum Transfer Price = Differential Cost per Unit + Lost CM per unit*
*lost contribution margin per unit on outside sales (or opportunity costs per unit)
The differential costs per unit is generally the variable costs per unit of the goods being
transferred, plus the contribution margin per unit that is lost by the selling division as a result of
giving up outside sales.
The minimum transfer price represents the lower limit since the selling division must receive at
least the amount shown by the formula in order to be as “well off” as if it sold only to outside
customers. As a rule, it should not exceed the purchase price from the outside supplier. If the
selling division has sufficient idle capacity to meet the demand of another division without
cutting into the sales of its regular customers, then it does not have any opportunity costs (lost
contribution margin). Hence, the lowest acceptable transfer price will be equal to the differential
or variable cost per unit. From the perspective of the buying division, the maximum acceptable
transfer price is equivalent to the price offered by the outside supplier.
Alternative Transfer Pricing Schemes
Market-based Transfer Price
If there is an outside market for the goods to be transferred and that outside market is perfectly
competitive, the current transfer price is the market price. Since the selling division can sell all
Page 2 of 3
that it produces at the market price, transferring internally at a lower price would make that
division worse off. Similarly, the buying division can always acquire the intermediate goods at
market price, so it would be unwilling to pay more for an internally transferred goods. Since the
minimum transfer price for the selling division is the market price and since the maximum price
for the buying division is also the market price, the only possible transfer price is the market
price!
In other words, if the selling division (with no idle capacity) can sell a transferred item on the
outside market instead, then the real cost of the transfer as far as the company as a whole is
concerned, is the opportunity cost of the lost revenue on the outside sale. Whether the item is
transferred internally or sold on the outside market, the production costs are exactly the same. If
the market price is used as the transfer price, the selling division manager will not lose anything
by making the transfer, and the buying division manager will get the correct signal about how
much it really costs the company for the transfer to take place.
Cost-based Transfer Price
a. Variable cost transfer price – transfer price is based only variable or differential costs.
But when fixed costs increase because of a transfer of goods, such costs will be
considered as differential costs and be included in the transfer price.
b. Full cost transfer price – transfer price includes actual manufacturing costs (both variable
and fixed) plus a portion of marketing and administrative costs.
Negotiated Transfer Price
Transfer price is set through a process of bargaining between the selling and buying segments.
Such prices are typically below the normal market price paid by the buying unit but not above
the selling segment’s combined incremental and opportunity costs. If such internal sales could
avoid any variable selling costs, then such costs are not considered. If external sales do not exist
or a division cannot downsize its facilities, no opportunity cost is involved.
Page 3 of 3
