Management Control

in Decentralized Organizations:
Transfer Pricing

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 Transfer Pricing (TP)
Transfer pricing deals with the valuation of goods and
services traded between profit or investment centers in
decentralized organizations

Department A Department B
Department A Department B Outside Market
TP for the Final
Product

Outside Market for

Intermediate Products

Selling division wants the transfer price to be high

Buying division wants the transfer price to be low
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 What is Effect of TP on the overall
company?
From the standpoint of the company as a whole,
the transfer price has no effect on aggregate
income (other than perhaps from tax effects
when divisions are in different countries).
What is counted as revenue to one division is a
cost to the other and is eliminated in the
consolidation process.

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 $800-850 million potentially owed by Cameco
includes both federal and provincial corporate
tax dollars

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 Basic Principles in Setting Transfer
Prices:
Motivate the divisional managers to act in the
best interests of the overall company; otherwise
sub-optimization can occur.
Provide information that is useful for evaluating
the managerial and economic performance of
the divisions.
Promote the coordination and communication
between responsibility centers.

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 MARKET-BASED TRANSFER

PRICES:
If there is a perfectly competitive market for the intermediate
product, then market price is the most appropriate basis for
pricing for the following reasons:
The market price provides an independent valuation of
the transferred product or service.
Use of market-based transfer prices promote goal
congruence.
The market prices also serve as a motivating force for
division managers to maximize their divisions operating
performance and to eliminate or restructure subunits that
cannot be operated profitably in the current market.
Adjustments should be made to reflect costs not incurred on
internally transferred goods and services

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 COST-BASED TRANSFER PRICES
If goods or services do not have market prices,
transfer prices are often based on cost.
Some common cost-based transfer prices are:
Variable cost
Full cost
Variable cost or full cost plus a percent
markup on cost
The use of cost-based transfer prices can result
in suboptimal decisions.

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 NEGOTIATED TRANSFER
PRICES:
In principle, if managers understand their own
businesses and are cooperative, negotiated
transfer prices should work quite well.
If a transfer is in the best interests of the entire
company, the profits of the entire company
should increase. It is always possible in such a
situation to find a transfer price that would
increase each participating divisions profits.

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 The Optimal TP
The Optimal TP is the price that maximizes the overall
(total) companys income.
The optimal transfer price should equal the variable (or
incremental) costs incurred by the transferring subunit in
order to produce the transferred units plus any opportunity
costs or forgone profits resulting from transferring the
products or service internally instead of selling them to
external customers.

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 THE RANGE OF ACCEPTABLE
TRANSFER PRICES:
Maximum Price: Market Price (if available)

Minimum Price: Variable (or incremental) costs

incurred by the transferring subunit in order to
produce the transferred units plus any
opportunity costs or forgone profits

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