It is a common occurrence that different segments within the same company supply goods and services to one another. In decentralized organizations, departments are run as individual units, and managers are responsible for profits, based on the departments’ revenue and expenses. When products are transferred out of one department and to another, a “transfer price” is set that allows the “selling” department to account for revenue and the “purchasing” department to account for costs – even if no actual money changes hands. Because the amounts of these goods and services can be quite large, the price that these segments charge each other can have a significant impact on the profits these departments recognize.
When different segments within a company operate in different countries, transfer prices are often set for tax purposes. Transfer prices are set so that the most amount of profit is declared in the country with the lower tax rate in order to minimize the company’s overall tax bill. As a result, in management accounting we focus on domestic transfer prices, that is, the transfer prices set between different segments in a company within the same country.
There are several reason why it is important to set appropriate domestic transfer prices. Transfer prices between segments within the same country are set in order to support greater divisional autonomy, to incentivize managers, to allow for better performance evaluation of divisions and to support an organizations overarching goals. Three common approaches to setting transfer prices are used:
: These transfer prices are set at an amount that will make both departments better off. As such, a negotiated transfer price will fall within a specific range. The selling department will want the transfer price to be at least as much as the variable cost per unit plus the lost contribution margin (if the units could be sold elsewhere). Similarly, the purchasing department will want the transfer price to be no higher than what the purchasing department can pay from an outside supplier.
Transfer price => (Variable cost per unit + total contribution margin on lost sales)/number of units transferred
Transfer price => cost of buying from outside supplier
: If a company can sell its products in the market rather than transfer them to another department, the real cost of the product is the opportunity cost of the lost sale to an outside buyer. Similarly, if the purchasing department can buy the product from an outside supplier, it would not want to pay more internally. Therefore, the transfer price may simply be set at the price available in an intermediate market.
: Many organizations set transfer costs by using either the selling departments variable costs or per-unit-cost based on absorption costing. This method is used because it is simple for accounting purposes: it does not require negotiations between managers of different departments, nor does it require determining the market value of an input (difficult to determine an accurate price). However, at-cost pricing has several drawbacks:
a. When costs are passed on to other departments, there is no incentive for the producing department to control costs
b. When prices aren’t negotiated or based on market information, there may be sub-optimal decision making
c. When costs are passed along, only departments that sell to outside buyers recognize a profit.
These three factors make it more difficult for transfer pricing to be used to incentivize and review performance.