Transfer Pricing

When one division sells a good or service to another division within the same company, a transfer price must be established. This is critical because it affects the profitability of both units and, therefore, managerial bonuses.

1. Cost-Based: Uses the selling unit’s full cost or variable cost. Simple, but offers no incentive for the selling unit to control costs.
2. Market-Based: Uses the price for similar goods in the open market. Best method, as it maintains goal congruence and unit autonomy, but requires a functional external market.
3. Negotiated: Units negotiate a price. Ideal for unique products, but can lead to internal friction.

Expansion and Key Considerations

Here’s a deeper look at the pros, cons, and the critical issues that make transfer pricing so important.

1. Cost-Based Transfer Pricing (Recap & Nuance)

• How it Works: Sets the price based on the cost incurred by the selling division.
  • Variable Cost: Only direct materials, labor, and variable overhead.
  • Full Cost: Variable cost + allocated fixed overhead.
  • Cost-Plus: Full cost + a markup for profit.
• Advantages (Why it’s still used):
  • Simple & Objective: Easy to understand and implement. Data is readily available from the accounting system.
  • Stable Prices: Provides predictability for both divisions.
  • Avoids “Insane” Internal Markups: Prevents the selling division from charging exorbitant prices to the buying division.
• Disadvantages (The “Devil in the Details”):
  • No Incentive for Cost Control (as you noted): If the selling division knows all costs will be covered, why work to reduce them? Inefficiencies are simply passed on.
  • Suboptimal for the Company: Using variable cost can make the selling division look unprofitable, demotivating its manager, even if it contributes to overall corporate fixed costs. Using full cost can lead the buying division to make bad decisions, as it sees an “artificially high” cost that includes fixed overhead that the company must pay regardless.
  • Defines “Cost”: What is the true cost? Actual cost? Standard cost? These choices can significantly alter the reported profitability of each division.

2. Market-Based Transfer Price (Recap & Nuance)

• How it Works: Uses the prevailing price for an identical or very similar product/service in the open market.
• Advantages (The Gold Standard):
  • Goal Congruence (as you noted): Both divisions act as if they are independent companies. The selling division has an incentive to be efficient (to earn a profit), and the buying division can source externally if the internal price is too high, ensuring competitiveness.
  • Fair Performance Evaluation: Divisional profit reflects real economic performance, not internal accounting rules.
  • Preserves Autonomy (as you noted): Treats division managers as leaders of their own businesses.
• Disadvantages (The Practical Hurdles):
  • No Clear Market Exists: This is the biggest limitation. For highly specialized, proprietary, or semi-finished components, there may be no external market.
  • Market Imperfections: The external market price might be temporarily depressed (a “fire sale”) or inflated, making it a poor benchmark.
  • Internal vs. External Costs: Selling internally often involves lower costs (no marketing, lower risk of bad debt, cheaper logistics). Should the internal price be adjusted to reflect these savings?

3. Negotiated Transfer Price (Recap & Nuance)

• How it Works: Division managers bargain with each other to arrive at a mutually acceptable price. The final price often falls somewhere between the seller’s cost and the external market price.
• Advantages (Pragmatic Flexibility):
  • Useful for Unique Situations: Ideal when no perfect market price exists but a cost-based price is deemed unfair.
  • Develops Managerial Skills: Forces managers to think strategically and negotiate, valuable skills for any business leader.
  • Can Achieve “Buy-in”: A price both parties agree to is more likely to be seen as fair.
• Disadvantages (The Human Element):
  • Time-Consuming and Frustrating (as you noted): Negotiations can break down, leading to internal conflict and resentment.
  • Inequitable Bargaining Power: If one division is much larger or has a more powerful manager, they can bully the other into an unfair price, destroying the goal congruence the system aims to create.
  • Corporate Intervention May Be Needed: Senior management often has to step in as a mediator, which undermines the autonomy of the divisions.

The Bigger Picture: Why Transfer Pricing is a Critical Issue

You correctly identified that it affects profitability and bonuses. This leads to several major corporate implications:

1. Performance Measurement and Managerial Incentives: This is the core internal issue. A poor transfer pricing system can make a efficient division look bad and an inefficient one look good, leading to unfair bonuses and poor decision-making.
2. Tax Implications (A Massive External Issue): For multinational companies, transfer pricing on cross-border transactions is heavily regulated. Governments (via the IRS, OECD, etc.) are keen to prevent companies from shifting profits to low-tax jurisdictions by manipulating internal prices (e.g., having a division in a high-tax country “sell” goods at a very low price to a division in a low-tax country). The penalties for non-compliance are severe. The “arm’s length principle” (i.e., the price should be what two independent companies would agree to) is the global standard, making the market-based method the one most favored by tax authorities.
3. Strategic Sourcing: Should the buying division be forced to buy internally? A “make-or-buy” decision for the company as a whole depends on the true variable cost of the selling division, not the transfer price.

Summary Table

In practice, many companies use a hybrid approach, often starting with a cost or market benchmark and then allowing for limited negotiation, all while ensuring they remain compliant with international tax laws.