Companies that are decentralized have a number of ways to evaluate performance of the responsibility centers. Recall that ROI, residual income, and EVA were used as performance measures. Decentralized companies must also deal with profit and cost center evaluation given centers such as these are crucial to operations. Profit and investment centers (segments or divisions) of a decentralized company often transfer their goods or provide services to each other and expect payment. The amount charged for these goods and services exchanged between them are referred to as transfer prices. A transfer price is the price that one division of a company charges another division of the same company for a product or service transferred between the two divisions. The goal is to choose a transfer price that adds the most value to the total company.
A couple of key points affect transfer prices:
There are no cash flows between the divisions. The transfer price is used only for accounting purposes. The transfer price is:
An expense for the division receiving the goods or services, and
A revenue for the division providing the goods or services,
Transfer prices affect division profits, not the whole company's profits. One exception: International transfer prices may affect the company’s total profit.
Transfer Price Approaches
The best transfer price is one that causes division managers to act in the best interest of the entire company.
There are four frequently used approaches to setting transfer prices. They are:
1. cost to the selling division - variable costs only
2. cost to the selling division - full costing
3. negotiated transfer prices
4. market price
Cost-based Transfer Pricing
Cost-based transfer prices do not provide incentives to managers to control costs. Why? the division providing the goods or services knows whatever cost is passed on will be recovered.
Cost-based transfers are based on the cost to the division providing the good or service. There are two options:
Based on variable costs of the division providing the goods or services.
Disadvantages: Does not cover fixed costs
Based on full costing (absorption) of the division providing the goods or services.
Disadvantages: May lead to sub-optimization due to fixed costs when fixed costs are not relevant are mixed with variable costs
No profit reported for the selling division
Division getting the goods or services shows a profit only if it makes the final sale (to customers)
Negotiated Transfer Pricing
Managers of the divisions involved get together and negotiate a price. An acceptable transfer price must:
Cause both divisions to have profit increases
With the lower limit idetermined by the selling division. I won't take less than $xx.
An the upper limit determined by the buying division. 'I won't pay more than $xx"
Divisions remain independent (i.e., the spirit of decentralization prevails.)
hose negotiating (managers of the two divisions) have much better information about costs and benefits of the transfer.
As you learned in financial accounting, market price is the amount charged for an item on the open market. This is usually the best approach to transfer pricing.
A market-based transfer price works best if:
1. The selling division has no idle capacity, and2. The product is sold to outside customers (with no process further adjustments)
The real cost is the opportunity cost of the lost contribution margin on the outside sale.
Problems may surface if the selling division has idle capacity because market transfer prices are likely to be higher than the variable cost per unit of the selling division. Why? Fixed costs are higher per unit when allocated.
International Aspects of Transfer Pricing
Transfer goods or services between divisions outside the US has advantages that enhance the selling company.
1. Taxes and tariffs are smaller when lower transfer prices are used .
2. Foreign exchange pricing risks are less when lower transfer prices are used.
3. Relations with foreign governments are improved.