Topic 4:

Management Control for

Decentralization and
Transfer pricing

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Lecture outline:
What is Transfer Price?
Objectives of transfer pricing
Transfer pricing & goal congruence
Methods of transfer pricing:
Cost- based, Market-based & Negotiated
Problems of transfer pricing and
divisional conflicts
Transfer prices in imperfect market
Dual pricing
International transfer pricing
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 What is TRANSFER PRICE?
Transfer Price (TP) is the amount charged when
one division sells goods or services to another
division within the same organisation

Sells
Pastry to

Pastry Division Pie Division

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 Transfer Pricing
TP affects the profit measure for both the
selling division and the buying division.
A higher TP
for pastry
means…

Pastry Division greater Pie Division

profits for
Pastry Division.
4
 Why concern about
Transfer Pricing?
The transfer price affects the profit measure for
both the selling division and the buying division.

A higher TP
for pastry
means . .

Pastry Division Pie Division

lower profits
for Pie Division 5
 The Main
Objective of
Transfer Pricing

To have the internal transfers to

take place
because the company will
benefit more when transfers
occur rather than buying from
external suppliers
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 OBJECTIVES OF TRANSFER
PRICING
1. Goal congruence: The prices should be set so that the
divisional management desire to maximize divisional
earnings is consistent with the objectives of the company
as a whole.
2. Performance appraisal: The prices should enable
reliable assessments to be made of divisional
performance. The prices form part of information, which
should:
– Guide decision making,
– Appraise managerial performance
– Evaluate the contribution made by the division to overall
company profits
– Assess the worth of the division as an economic unit.
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 OBJECTIVES OF TRANSFER
PRICING
3. Divisional autonomy: The prices should seek to
maintain the maximum divisional autonomy so that the
benefits of decentralisation (motivation, better decision
making etc) are maintained.
The profits of one division should not be dependent on
the actions of other divisions.
4. Simple and easy: The system should be simple to
understand and easy to administer.
5. The transfer price should provide each segment with the
relevant information required to determine the optimum
trade-off between company costs and revenues.
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 Congruence in
Transfer Pricing
An ideal transfer price allows
each division manager to make
decisions that maximise the
company’s profit, while
attempting to maximize his/her
own division’s profit.
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General-Transfer-Pricing
Rule
Additional outlay Opportunity cost
cost per unit per unit to the
TP = incurred because + organization
goods are because of
transferred the transfer

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 FLOURY FOOD INDUSTRY (FFI)

• Two of the company’s divisions are Pastry

Division and Pies Division.
• Pastry Division makes a standard 300g pastry
which are sold to external market as well as to
Pie Division
• The Pastry division sells 300,000 packets of
pastries to outside customers at RM4 per packet.
• The Pie Division uses pastries in production of its
fruit pies.

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 Scenario I:
No Excess Capacity
• The information related to Pastry Division operation:
Production capacity 300,000 units
Variable costs per pastry RM1.80
Fixed costs per pastry RM0.70 (at 300,000 units)
• Currently, Pastry division sells 300,000 packets of
pastries to outside customers at RM4 per packet.
• The Pie Division can use 300,000 of these pastries in
its fruit pies.
What is the appropriate TP if Pastry
Division sells its pastries to Pie Division?
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 Scenario I:
No Excess Capacity

Transfer = Additional outlay + Opportunity cost

price cost per unit per unit to the
incurred because organization
goods are because of
transferred the transfer
= RM1.80 variable + RM2.20
cost per pastry contribution loss
if outside sales
is given up
= RM4.00 per unit
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 Scenario I:
No Excess Capacity
Pie Division can Pie Division can
purchase 300,000 purchase 300,000
pastries from an pastries from an
outside supplier outside supplier
for less than RM4 for more than RM4

Transfer will Transfer

RM4
not occur will occur
transfer
price
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 Scenario I:
No Excess Capacity

THE GENERAL RULE

• When the selling division is operating at
full capacity, the transfer price should be
set at the market price (TP = MP)

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 Scenario II:
Excess Capacity
• The Pastry Division makes a standard 300g pastry:
Production capacity 300,000 packets
Variable costs per unit RM1.80
Fixed costs per unit RM1.70 (at 300,000 units)
• Currently, Pastry division sells 150,000 packets of
pastries to outside customers at RM4 each.
• The Pie Division can use 100,000 packets of pastries
in production of fruit pies. The pastries can be
obtained from an outside supplier at RM3.80 each.
What is the appropriate TP if Pie Division buy
the pastries from Pastry Division?
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 Scenario II:
Excess Capacity
Transfer = Additional outlay + Opportunity cost
price cost per unit per unit to the
incurred because organization
goods are because of
transferred the transfer

= RM1.80 variable + RM0

cost per pastry
= RM1.80 per unit

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 Scenario II:
Excess Capacity
General Rule
When the selling division is operating
below capacity, the minimum transfer
price is the variable cost per unit.
So, the transfer price should be no lower
than RM1.80, and no higher than RM3.80

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 Scenario II:
Excess Capacity
Transfer Transfer Transfer
will not will will not
occur. occur. occur.

RM1.80 RM3.80
transfer transfer
price price

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 Setting Transfer Prices
The value placed on transfer goods is
used to make it possible to transfer
goods between divisions while allowing
them to retain their autonomy.

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Criteria of Effective Transfer
Pricing System
 Allow divisional autonomy be
maintained, as continued autonomy
should motivate divisional managers to
perform their best
 Allow divisional performance be
assessed objectively. PMS set should
properly reflect divisional performance
 Ensure divisional managers make
decisions that are in the best interests
of both divisions, & benefits the
company as the whole
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Goal Congruence
Conflicts may arise
between the company’s
interests and an individual
manager’s interests when
transfer-price-based
performance measures are
used

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 Setting Transfer Prices

Conflicts may be resolved by:

Direct intervention by top management.
Centrally established transfer price
policies.
Negotiated transfer prices
Dual pricing

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 Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.

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 Administered or Centrally
Established Transfer Prices
As a general rule, a market price-based
transfer pricing policy contains the
following guidelines . . .
 The transfer price is usually set at a
discount from the cost to acquire the item
on the open market.
 The selling division may elect to transfer or
to continue to sell to the outside.
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 Administered / Centrally
Established Transfer Prices

As a general rule, a market price-based

transfer pricing policy contains the
following guidelines . . .
 The transfer price is usually set at a
discount from the cost to acquire the item
on the open market.
 The selling division may elect to transfer or
to continue to sell to the outside.
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 Negotiating the Transfer Price
A system where transfer prices are arrived at
through negotiation between managers of
buying and selling divisions.

Much management
time is used in the
negotiation process.

Negotiated price may not

be in the best interest of
overall company operations.
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Cost-Based Transfer Prices
Some companies use the following
measures of cost to establish transfer
prices . . .

• Variable cost
• Full absorption cost
(Beware of treating unit fixed
costs as variable)

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 TRANSFER PRICING TO
RESOLVE CONFLICTS
• The following transfer pricing methods
have been suggested:
 Adopt a dual-rate TP system
 Transfer at a marginal cost plus a fixed
lump-sum fee

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 DUAL-RATE TP
SYSTEM
• It can be implemented where Selling Division
recording transfer at Full Cost plus Mark up; while
the Buying Division be charged at the marginal
cost of the transfer
• It is not widely used in practice because:
 Using different prices would be confusing
 They reduce divisional incentives to compete
effectively
 May lead to misleading information as internal profits
are double counted
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TP in Imperfect Markets
Transfer pricing can be complex
when selling and buying divisions
cannot sell and buy all they want
in perfectly competitive markets.

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 International
Transfer Pricing
Since tax rates and import duties are different in
different countries, companies have incentives
to set transfer prices that will:
 Increase revenues in low-tax countries.
 Increase costs in high-tax countries.
 Reduce cost of goods transferred to high-
import-duty countries

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 Behavioral Issues:
Risk Aversion &
Incentives
The design of a managerial performance
evaluation system using financial performance
measures involves a trade-off between:

Incentives for the Risks imposed on the manager

manager to act in Because financial performance
the organization’s and measures are only
interests. partially controlled by the manager.

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 Goal Congruence and
Internal Control Systems
A well-designed internal control system
includes a set of procedures to prevent
these major lapses in responsible behavior:
• Fraud
• Corruption
• Financial Misrepresentation
• Unauthorized Action

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 End of
Lecture 4

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