Transfer Pricing

1 Introduction

Where an organisation is divisionalised, one division will often supply components, products or services to another. Because each division's performance is measured separately (chapter 5), it matters a great deal to both managers what price is charged for that internal supply.

That price is the transfer price. This chapter covers what it is and why one is needed; how a badly set transfer price destroys goal congruence; the rule for setting a sensible one, including where an external market exists and where it does not; the main methods used in practice and when each is appropriate; the effect of transfer pricing on divisional autonomy, motivation and group profitability; and the ethics of the whole exercise.

2 What is a transfer price?

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The transfer price is the price at which one division of a company charges another division of the same company for goods or services supplied. It is an internal charge: the “sale” of one division is the “cost” of the other.

3 Why a transfer price is needed

A transfer price is needed when two conditions are both met: the organisation is structured into divisions whose results are measured separately, and those divisions trade with each other.

3.1 Internal trading

Internal trading is the supply of goods or services by one responsibility centre to another within the same organisation. Without a transfer price the supplying division records only costs and reports a permanent loss, while the receiving division earns revenue on goods that cost it nothing and reports a flattering profit. Neither figure measures anything. Returning to Example 1: with no transfer price Division A reports a loss of $10 per unit and Division B a profit of $16 — and the company still makes $6.

Division A will be reluctant to supply at all if every transfer is recorded as a loss-making sale. The problem becomes sharper still if A could sell the same goods on an external market instead.

3.2 Internal competition

Internal competition is what happens when divisions, given autonomy and measured separately, begin to compete with each other rather than with the outside world. It takes three common forms:

• Competing over the transfer price itself. The supplying division wants it high, the receiving division wants it low, and every dollar one gains the other loses. The argument is about the division of a fixed sum, so it is zero-sum by construction.

• Competing in the same external market. Two divisions can end up bidding against each other for the same customer, or a supplying division can find itself selling to its own internal customer's competitor.

• Competing for scarce internal resources — capital, skilled staff, central specialists — which is dealt with by the capital budget (chapter 10) rather than by the transfer price.

Some internal competition is healthy: a division that must match an external market price has a real incentive to be efficient. It becomes destructive when it produces decisions that are good for one division and bad for the group, which is the subject of sections 5 and 6, or when managers stop sharing information with each other.

A further reason for taking the transfer price seriously is that where the divisions are in different countries the price determines where the group's profit is taxed. That is dealt with in section 10.2, and its ethical dimension in section 11.

4 Cost-plus transfer pricing

The commonest approach in practice is a group-wide policy: goods transferred between divisions are charged at the cost to the supplying division plus a fixed percentage. It is administratively simple, which is its whole attraction — one memo covers every product and every division.

4.1 Two problems with cost-plus

1. It removes the supplying division's incentive to cut costs. The whole point of divisionalisation is to motivate managers to improve. Under a cost + 20% rule, Division A's profit is 20% of its own costs — so if A cuts its costs from $15 to $10, its profit falls from $3 to $2. The only way A can report more profit is to spend more. The measure instructs the manager to do the opposite of what the group wants.

2. It can destroy goal congruence — section 5.

Which cost is used matters as well. Under full cost plus, the supplying division's fixed costs arrive in the buying division as an apparently variable cost per unit, and the buying division then makes decisions — accept an order, quote a price — using a marginal cost that is not the group's marginal cost at all.

5 Goal congruence

Each divisional manager has autonomy, so each decides for themselves whether a product is worth making or buying. (Assume throughout that each division makes a range of products, so that dropping one does not change its fixed costs.) A decision is goal congruent when the decision that is best for the division is also the decision that is best for the group.

6 Setting a sensible transfer price

In the examination you may be asked to select a sensible transfer price, or to give a range of acceptable prices. There is a rule, and it is stated in section 7 — but it is much easier to use once the logic behind it is clear, so the following four short examples build it up.

The method is always the same two questions. What is the least the supplying division will accept? and what is the most the receiving division will pay?

7 The rule for sensible transfer pricing

The four examples above give the rule. It has two halves, and they are set by different divisions.

7.1 Minimum transfer price — set by the transferring (supplying) division

Minimum = Marginal cost of the transferring division + Contribution forgone by transferring

The contribution forgone is an opportunity cost and it is zero unless the supplying division has limited capacity and could have sold the units elsewhere. Look for the capacity constraint first: no constraint, no lost contribution, and the minimum is simply marginal cost.

7.2 Maximum transfer price — set by the receiving (buying) division

Maximum = the lower of: net marginal revenue, and the external purchase price

Net marginal revenue = Final selling price − Buying division's own marginal costs

The external purchase price applies only if the buying division can in fact buy the intermediate product outside. If it cannot, the maximum is the net marginal revenue.

Any price inside the range produces goal congruence, and where inside it falls decides only how the group's profit is divided between the two divisions — which is a matter for negotiation, or for head office to settle if the managers cannot. If the minimum exceeds the maximum there is no goal-congruent transfer price, and that is itself the answer: the transfer destroys value and should not take place. The buying division should source outside, or the product should not be made.

8 Capacity limitations and opportunity cost

Where the supplying division's capacity is limited and it makes more than one product, the contribution forgone is not simply the contribution on the transferred product. It is the contribution on the best alternative use of the scarce resource, which is found in the usual way: contribution per unit of the limiting factor.

9 Types of transfer price and when to use them

The syllabus asks for transfer pricing where markets exist and where no market exists, and for the types of transfer price and when each is used. The two questions are the same question, because the presence of an external market for the intermediate product is what decides the method.

9.1 Where an external market exists

The market price is the natural transfer price, and where the market is competitive and the supplying division is operating at capacity it is also the theoretically correct one — as Example 6 showed, market price there equals marginal cost plus contribution forgone.

• It encourages efficiency: each division has to compete with the outside world rather than with a formula.

• It is objective, so it is harder to argue about, and it is the basis tax authorities expect (section 10.2).

• But there is rarely one market price — prices vary by quantity, contract and time, and quoted prices fluctuate; and where the supplying division has spare capacity the market price is too high, because there is then no contribution forgone and the group would want a transfer at any price above marginal cost. An adjusted market price — market price less the selling, delivery and credit costs avoided on an internal sale — answers part of this.

9.2 Where no external market exists

Without a market price the price has to be built from cost, and the choice is then between the following.

10 Effects of transfer pricing

10.1 On autonomy, motivation and divisional profitability

10.2 On group profitability where tax jurisdictions differ

Where the two divisions are in different countries, the transfer price decides how much of the group's profit is earned — and therefore taxed — in each. The group's pre-tax profit is unaffected; its post-tax profit is not.

11 The use and ethics of transfer pricing

Transfer pricing is one of the few places in management accounting where the same number serves two masters — it measures divisional performance and it determines where profit is taxed — and where the accountant setting it is often the person whose own division gains or loses by the choice. That is what makes it an ethical topic and not only a technical one.

11.1 Ethical issues inside the group

• Manipulating divisional results. A transfer price can be moved to flatter one division, to protect a manager's bonus, to make a division look worth keeping, or to make one look worth closing. The figures are not false; the comparison they support is.

• Inflating cost under a cost-plus policy. Where the price is cost + x%, the supplying division has a direct financial interest in its own costs being high, and in how they are measured. Standard rather than actual cost (section 9.2) removes most of that opportunity.

• Autonomy in name only. Requiring divisions to trade internally at a price they had no part in setting, and then holding their managers responsible for the result, is not fair even where it is efficient.

• Selective disclosure. Presenting a divisional performance report without disclosing the transfer pricing policy behind it leaves the reader unable to interpret it.

11.2 Ethical issues outside the group

The external issue is profit shifting: setting transfer prices so that profit arises in low-tax jurisdictions. The technical boundary is the arm's length principle — the price independent parties would have agreed — and the boundary in law is between:

1. Tax planning — arranging genuine commercial activity, and pricing it defensibly, so that no more tax is paid than is due. Legitimate.

2. Tax avoidance — arrangements within the letter of the law but outside its purpose. Lawful, and increasingly challenged; and legality is not the same as acceptability. A group whose arrangements become public may lose more in reputation and customer goodwill than it saved in tax.

3. Tax evasion — misrepresenting the facts. Illegal, and no accountant may take part in it.

11.3 Applying the Code's fundamental principles

Where a management accountant is pressed to set a transfer price they believe cannot be justified, the response is the standard one: establish the facts, raise it with the appropriate level of management, use the employer's own ethics and grievance procedures, take confidential advice from the professional body, and document each step. If the matter cannot be resolved, the accountant must not be associated with the information — which may in the last resort mean resigning.

12 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.