Divisional Performance and Transfer Pricing

Divisional Performance and Transfer Pricing

1. Divisionalisation: Divisionalisation is a term for the division of an organisation into divisions. Each divisional manager is responsible for the performance of the division. A division may be a cost centre (responsible for its costs only), a profit centre (responsible for revenues and profits) or an investment centre or Strategic Business Unit (responsible for costs, revenues and assets).

In general, a large organisation can be structured in one of two ways: functionally (all activities of a similar type within a company, such as production, sales and research, are under the control of the appropriate departmental head) or divisionally (split into divisions in accordance with the products or services made or provided).

Divisional managers are therefore responsible for all operations (production, sales, and so on) relating to their product, the functional structure being applied to each division. It is possible, of course, that only part of a company is divisionalised and activities such as administration are structured centrally on a functional basis with the responsibility of providing services to all divisions.

1.1 Decentralisation: In general, a divisional structure will lead to decentralisation of the decision making process and divisional managers may have the freedom to set selling prices, choose suppliers, make product mix and output decisions, and so on. Decentralisation is, however, a matter of degree, depending on how much freedom divisional managers are given.

1.2 Advantages of divisionalisation

(a) Divisionalisation can improve the quality of decisions made because divisional managers (those taking the decisions) know local conditions and are able to make more informed judgements. Moreover, with the personal incentive to improve the division's performance, they ought to take decisions in the division's best interests.

(b) Decisions should be taken more quickly because information does not have to pass along the chain of command to and from top management. Decisions can be made on the spot by those who are familiar with the product lines and production processes and who are able to react to changes in local conditions quickly and efficiently.

(c) The authority to act to improve performance should motivate divisional managers.

(d) Divisional organisation frees top management from detailed involvement in day-to-day operations and allows them to devote more time to strategic planning.

(e) Divisions provide valuable training grounds for future members of top management by giving them experience of managerial skills in a less complex environment than that faced by top management.

(f) In a large business organisation, the central head office will not have the management resources or skills to direct operations closely enough itself. Some authority must be delegated to local operational managers.

1.3 Disadvantages of divisionalisation

(a) A danger with divisional accounting is that the business organisation will divide into a number of self-interested segments, each acting at times against the wishes and interests of other segments. Decisions might be taken by a divisional manager in the best interests of their own part of the business, but against the best interest of other divisions and possibly against the interests of the organisation as a whole.

A task of head office is therefore to try to prevent dysfunctional decision-making by individual divisional managers. To do this, head office must reserve some power and authority for itself so that divisional managers cannot be allowed to make entirely independent decisions. A balance ought to be kept between decentralisation of authority to provide incentives and motivation, and retaining centralised authority to ensure that the organisation's divisions are all working towards the same target, the benefit of the organisation as a whole (in other words, retaining goal congruence among the organisation's separate divisions).

(b) It is claimed that the costs of activities that are common to all divisions, such as running the accounting department, may be greater for a divisionalised structure than for a centralised structure.

(c) Top management, by delegating decision-making to divisional managers, may lose control since they are not aware of what is going on in the organisation as a whole. (With a good system of performance evaluation and appropriate control information, however, top management should be able to control operations just as effectively.)

1.4 Responsibility accounting: Responsibility accounting is the term used to describe decentralisation of authority, with the performance of the decentralised units measured in terms of accounting results.

With a system of responsibility accounting there are five types of responsibility centre: cost centre; revenue centre; profit centre; contribution centre; and investment centre.

The creation of divisions allows for the operation of a system of responsibility accounting. There are a number of types of responsibility accounting unit, or responsibility centre that can be used within a system of responsibility accounting.

In the weakest form of decentralisation a system of cost centres might be used. As decentralisation becomes stronger the responsibility accounting framework will be based around profit centres. In its strongest form investment centres are used.

Type of responsibility centre	Manager has control over …	Principal performance measures
Cost centre	Controllable costs	Variance analysis Efficiency measures
Revenue centre	Revenues only	Revenues
Profit centre	Controllable costs Sales prices (including transfer prices)	Profit
Contribution centre	As for profit centre except that expenditure is reported on a marginal cost basis	Contribution
Investment centre	Controllable costs Sales prices (including transfer prices) Output volumes Investment in non-current assets and working capital	Return on investment Residual income Other financial ratios

2. Return on investment (ROI): The performance of an investment centre is usually monitored using either or both return on investment (ROI) and residual income (RI).

ROI is generally regarded as the key performance measure. The main reason for its widespread use is that it ties in directly with the accounting process, and is identifiable from the income statement and balance sheet. However, it does have limitations, as we will see later in this chapter.

Return on investment (ROI) shows how much profit has been made in relation to the amount of capital invested and is calculated as (profit/capital employed) × 100%.

For example, suppose that a company has two investment centres, A and B, which show results for the year as follows.

	A	B
	$	$
Profit	60,000	30,000
Capital employed	400,000	120,000
ROI	15%	25%

Investment centre A has made double the profits of investment centre B and in terms of profits alone has therefore been more 'successful'. However, B has achieved its profits with a much lower capital investment and so has earned a much higher ROI. This suggests that B has been a more successful investment than A.

2.1 Measuring ROI: There is no generally agreed method of calculating ROI, and it can have behavioural implications and lead to dysfunctional decision-making when used as a guide to investment decisions. It focuses attention on short-run performance whereas investment decisions should be evaluated over their full life.

ROI can be measured in different ways.

2.1.1 Profit after depreciation as a % of net assets employed

This is probably the most common method, but it does present a problem. If an investment centre maintains the same annual profit, and keeps the same assets without a policy of regular replacement of non-current assets, its ROI will increase year by year as the assets get older. This can give a false impression of improving performance over time.

For example, the results of investment centre X, with a policy of straight-line depreciation of assets over a five-year period, might be as follows.

	Non - current
Year	assets	Depreciation	NBV	Working	Capital
	at cost	in the year	(mid year)	capital	employed	Profit	ROI
	$'000	$'000	$'000	$'000	$'000	$'000
0	100			10	110
1	100	20	90	10	100	10	10.0%
2	100	20	70	10	80	10	12.5%
3	100	20	50	10	60	10	16.7%
4	100	20	30	10	40	10	25.0%
5	100	20	10	10	20	10	50.0%

This table of figures is intended to show that an investment centre can improve its ROI year by year simply by allowing its non-current assets to depreciate, and there could be a disincentive to investment centre managers to reinvest in new or replacement assets, because the centre's ROI would probably fall.

This example has used a mid-year NBV but a year end or start of year NBV can also be used.

A further disadvantage of measuring ROI as profit divided by net assets is that, for similar reasons, it is not easy to compare fairly the performance of investment centres. For example, suppose that we have two investment centres.

                                                            Investment centre P                  Investment centre Q

Working capital	$	$ 20,000	$	$ 20,000
Non-current assets at cost	230,000		230,000
Accumulated depreciation Net book value	170,000	60,000	10,000	220,000
Capital employed		80,000		240,000
Profit		$24,000		$24,000
ROI		30%		10%

Investment centres P and Q have the same amount of working capital, the same value of non-current assets at cost and the same profit. However, P's non-current assets have been depreciated by a much bigger amount (presumably P's non-current assets are much older than Q's) and so P's ROI is three times the size of Q's ROI. The conclusion might therefore be that P has performed much better than Q. This comparison, however, would not be 'fair', because the difference in performance might be entirely attributable to the age of their non-current assets.

The arguments for using net book values for calculating ROI

(a) It is the 'normally accepted' method of calculating ROI.

(b) Organisations are continually buying new non-current assets to replace old ones that wear out and so, on the whole, the total net book value of all non-current assets together will remain fairly constant (assuming nil inflation and nil growth).

2.1.2 Profit after depreciation as a % of gross assets employed: Instead of measuring ROI as return on net assets, we could measure it as return on gross assets i.e. before depreciation. This would remove the problem of ROI increasing over time as non-current assets get older.

If a company acquired a non-current asset costing $40,000, which it intends to depreciate by $10,000 pa for four years, and if the asset earns a profit of $8,000 pa after depreciation, ROI might be calculated on net book values or gross values, as follows.

		NBV (mid-	ROI based on		ROI based on
Year	Profit	year value)	NBV	Gross value	gross value
	$	$		$
1	8,000	35,000	22.9%	40,000	20%
2	8,000	25,000	32.0%	40,000	20%
3	8,000	15,000	53.3%	40,000	20%
4	8,000	5,000	160.0%	40,000	20%

The ROI based on net book value shows an increasing trend over time, simply because the asset's value is falling as it is depreciated. The ROI based on gross book value suggests that the asset has performed consistently in each of the four years, which is probably a more valid conclusion.

However, using gross book values to measure ROI has its disadvantages. Most important of these is that measuring ROI as return on gross assets ignores the age factor, and does not distinguish between old and new assets.

(a) Older non-current assets usually cost more to repair and maintain, to keep them running. An investment centre with old assets may therefore have its profitability reduced by repair costs, and its ROI might fall over time as its assets get older and repair costs get bigger.

(b) Inflation and technological change alter the cost of non-current assets. If one investment centre has non-current assets bought ten years ago with a gross cost of $1 million, and another investment centre in the same area of business operations has non-current assets bought very recently for $1 million, the quantity and technological character of the non-current assets of the two investment centres are likely to be very different.

2.1.3 Constituent elements of the investment base: Although we have looked at how the investment base should be valued, we need to consider its appropriate constituent elements.

(a) If a manager's performance is being evaluated, only those assets which can be traced directly to the division and are controllable by the manager should be included. Head office assets or investment centre assets controlled by head office should not be included. So, for example, only those cash balances actually maintained within an investment centre itself should be included.

(b) If it is the performance of the investment centre that is being appraised, a proportion of the investment in head office assets would need to be included because an investment centre could not operate without the support of head office assets and administrative backup.

2.1.4 Profits: We have looked at how to define the asset base used in the calculations but what about profit? If the performance of the investment centre manager is being assessed it should seem reasonable to base profit on the revenues and costs controllable by the manager and exclude service and head office costs except those costs specifically attributable to the investment centre. If it is the performance of the investment centre that is being assessed, however, the inclusion of general service and head office costs would seem reasonable.

The profit figure for ROI should always be the amount before any interest is charged.

2.1.5 Massaging the ROI: If a manager's large bonus depends on ROI being met, the manager may feel pressure to massage the measure. The asset base of the ratio can be altered by increasing/decreasing payables and receivables (by speeding up or delaying payments and receipts).

2.2 ROI and new investments: If investment centre performance is judged by ROI, we should expect that the managers of investment centres will probably decide to undertake new capital investments only if these new investments are likely to increase the ROI of their centre.

Suppose that an investment centre, A, currently makes a return of 40% on capital employed. The manager of centre A would probably only want to undertake new investments that promise to yield a return of 40% or more, otherwise the investment centre's overall ROI would fall.

For example, if investment centre A currently has assets of $1,000,000 and expects to earn a profit of $400,000, how would the centre's manager view a new capital investment which would cost $250,000 and yield a profit of $75,000 pa?

	Without the new investment	With the new investment
Profit	$400,000	$475,000
Capital employed	$1,000,000	$1,250,000
ROI	40%	38%

The new investment would reduce the investment centre's ROI from 40% to 38%, and so the investment centre manager would probably decide not to undertake the new investment.

If the group of companies of which investment centre A is a part has a target ROI of, say, 25%, the new investment would presumably be seen as beneficial for the group as a whole. But even though it promises to yield a return of 75,000/250,000 = 30%, which is above the group's target ROI, it would still make investment centre A's results look worse. The manager of investment centre A would, in these circumstances, be motivated to do not what is best for the organisation as a whole, but what is best for his division.

ROI should not be used to guide investment decisions but there is a difficult motivational problem. If management performance is measured in terms of ROI, any decisions which benefit the company in the long term but which reduce the ROI in the immediate short term would reflect badly on the manager's reported performance. In other words, good investment decisions would make a manager's performance seem worse than if the wrong investment decision were taken instead.

3. Residual income (RI): RI can sometimes give results that avoid the behavioural problem of dysfunctionality. Its weakness is that it does not facilitate comparisons between investment centres nor does it relate the size of a centre's income to the size of the investment.

An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost.

(a) The centre's profit is after deducting depreciation on capital equipment.

(b) The imputed cost of capital might be the organisation's cost of borrowing or its weighted average cost of capital.

Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost.

3.1 The advantages and weaknesses of RI compared with ROI: The advantages of using RI

(a) Residual income will increase when investments earning above the cost of capital are undertaken and investments earning below the cost of capital are eliminated.

(b) Residual income is more flexible since a different cost of capital can be applied to investments with different risk characteristics.

The weakness of RI is that it does not facilitate comparisons between investment centres nor does it relate the size of a centre's income to the size of the investment.

3.2 RI versus ROI: marginally profitable investments: Residual income will increase if a new investment is undertaken which earns a profit in excess of the imputed interest charge on the value of the asset acquired. Residual income will go up even if the investment only just exceeds the imputed interest charge, and this means that 'marginally profitable' investments are likely to be undertaken by the investment centre manager.

In contrast, when a manager is judged by ROI, a marginally profitable investment would be less likely to be undertaken because it would reduce the average ROI earned by the centre as a whole.

3.2.1 Example: ROI versus residual income: Suppose that Department H has the following profit, assets employed and an imputed interest charge of 12% on operating assets.

	$	$
Operating profit	30,000
Operating assets		100,000
Imputed interest (12%)	12,000
Return on investment		30%
Residual income	18,000

Suppose now that an additional investment of $10,000 is proposed, which will increase operating income in Department H by $1,400. The effect of the investment would be:

	$	$
Total operating income	31,400
Total operating assets		110,000
Imputed interest (12%)	13,200
Return on investment		28.5%
Residual income	18,200

If the Department H manager is made responsible for the department's performance, they would resist the new investment if they were to be judged on ROI, but would welcome the investment if they were judged according to RI, since there would be a marginal increase of $200 in residual income from the investment, but a fall of 1.5% in ROI.

The marginal investment offers a return of 14% ($1,400 on an investment of $10,000) which is above the 'cut-off rate' of 12%. Since the original return on investment was 30%, the marginal investment will reduce the overall divisional performance. Indeed, any marginal investment offering an accounting rate of return of less than 30% in the year would reduce the overall performance.

4. Transfer pricing: Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the measurement of divisional performance or discouraging overall corporate profit maximisation.

Transfer prices should be set at a level which ensures that profits for the organisation as a whole are maximised.

Transfer pricing is used when divisions of an organisation need to charge other divisions of the same organisation for goods and services they provide to them. For example, subsidiary A might make a component that is used as part of a product made by subsidiary B of the same company, but that can also be sold to the external market, including makers of rival products to subsidiary B's product. There will therefore be two sources of revenue for A.

(a) External sales revenue from sales made to other organisations

(b) Internal sales revenue from sales made to other responsibility centres within the same organisation, valued at the transfer price

A transfer price is the price at which goods or services are transferred from one department to another, or from one member of a group to another.

4.1   Problems with transfer pricing

4.1.1 Maintaining the right level of divisional autonomy: Transfer prices are particularly appropriate for profit centres because if one profit centre does work for another the size of the transfer price will affect the costs of one profit centre and the revenues of another.

However, as we have seen, a danger with profit centre accounting is that the business organisation will divide into a number of self-interested segments, each acting at times against the wishes and interests of other segments. Decisions might be taken by a profit centre manager in the best interests of their own part of the business, but against the best interests of other profit centres and possibly the organisation as a whole.

4.1.2 Ensuring divisional performance is measured fairly: Profit centre managers tend to put their own profit performance above everything else. Since profit centre performance is measured according to the profit they earn, no profit centre will want to do work for another and incur costs without being paid for it. Consequently, profit centre managers are likely to dispute the size of transfer prices with each other, or disagree about whether one profit centre should do work for another or not. Transfer prices affect behaviour and decisions by profit centre managers.

4.1.3 Ensuring corporate profits are maximised: When there are disagreements about how much work should be transferred between divisions, and how many sales the division should make to the external market, there is presumably a profit-maximising level of output and sales for the organisation as a whole. However, unless each profit centre also maximises its own profit at this same level of output, there will be interdivisional disagreements about output levels and the profit-maximising output will not be achieved.

4.1.4 The ideal solution: Ideally a transfer price should be set at a level that overcomes these problems.

(a) The transfer price should provide an 'artificial' selling price that enables the transferring division to earn a return for its efforts, and the receiving division to incur a cost for benefits received.

(b) The transfer price should be set at a level that enables profit centre performance to be measured 'commercially'. This means that the transfer price should be a fair commercial price.

(c) The transfer price, if possible, should encourage profit centre managers to agree on the amount of goods and services to be transferred, which will also be at a level that is consistent with the aims of the organisation as a whole, such as maximising company profits.

In practice it is difficult to achieve all three aims.

4.2 General rules: The limits within which transfer prices should fall are as follows.

• The minimum: The sum of the supplying division's marginal cost and opportunity cost of the item transferred.

• The maximum: The lowest market price at which the receiving division could purchase the goods or services externally, less any internal cost savings in packaging and delivery.

The minimum results from the fact that the supplying division will not agree to transfer if the transfer price is less than the marginal cost + opportunity cost of the item transferred (because if it were, the division would incur a loss).

The maximum results from the fact that the receiving division will buy the item at the cheapest price possible.

4.2.1 Example: general rules: Division X produces product L at a marginal cost per unit of $100. If a unit is transferred internally to division Y, $25 contribution is forgone on an external sale. The item can be purchased externally for $150.

• The minimum. Division X will not agree to a transfer price of less than $(100 + 25) = $125 per unit.

• The maximum. Division Y will not agree to a transfer price in excess of $150.

The difference between the two results ($25) represents the savings from producing internally as opposed to buying externally.

4.2.2 Opportunity cost: The opportunity cost included in determining the lower limit will be one of the following.

(a) The maximum contribution forgone by the supplying division in transferring internally rather than selling goods externally.

(b) The contribution forgone by not using the same facilities in the producing division for their next best alternative use.

If there is no external market for the item being transferred, and no alternative uses for the division's facilities, the transfer price = standard variable cost of production.

If there is an external market for the item being transferred and no alternative, more profitable use for the facilities in that division, the transfer price = the market price.

4.2.3 Example: The transfer price at full and spare capacity: The factors that influence the transfer price charged when divisions are operating at full capacity and spare capacity are best illustrated using an example.

Until recently, Strike Ltd focused exclusively on making soles for work boots and football boots. It sold these rubber soles to boot manufacturers. Last year the company decided to take advantage of its strong reputation by expanding into the business of making football boots. As a consequence of this expansion, the company is now structured as two independent divisions, the Boot Division and the Sole Division.

The Sole Division continues to make rubber soles for both football boots and work boots and sells these soles to other boot manufacturers. The Boot division manufactures leather uppers for football boots and attaches these uppers to rubber soles. During its first year the Boot Division purchased its rubber soles from outside suppliers so as not to disrupt the operations of the Sole Division.

Strike management now wants the Sole Division to provide at least some of the soles used by the Boot Division. The table below shows the contribution margin for each division when the Boot Division purchases from an outside supplier.

	Boot Division $		Sole Division $
Selling price of football boot	100	Selling price of sole	28
Variable cost of making boot (not including sole)	45	Variable cost per sole	21
Cost of sole purchased from outside suppliers	25
Contribution margin per unit	30	Contribution margin per unit	7

The information above indicates that the total contribution margin per unit is $37 ($30 + $7).

Required: What would be a fair transfer price if the Sole Division sold 10,000 soles to the Boot Division?

Solution: The answer depends on how busy the Sole Division is – that is, whether it has spare capacity. No spare capacity

As indicated above, the Sole Division charges $28 and derives a contribution margin of $7 per sole. The Sole Division has no spare capacity and produces and sells 80,000 units (soles) to outside customers. Therefore, the Sole Division must receive from the Boot Division a payment that will at least cover its variable cost per sole plus its lost contribution margin per sole (the opportunity cost). If the Sole Division cannot cover that amount (the minimum transfer price), it should not sell soles to the Boot Division. The minimum transfer price that would be acceptable to the Sole Division is $28, as shown below.

$21 (variable cost) + $7 (opportunity cost) = $28

Spare capacity: The minimum transfer price is different if a division has spare capacity. Assume the Sole Division produces 80,000 soles but can only sell 70,000 to the open market. As a result, it has available capacity of 10,000 units. In this situation, the Sole Division does not lose its contribution margin of $7 per unit, and therefore the minimum price it would now accept is $21 as shown below.

$21 (variable cost) + $0 (opportunity cost) = $21

In this case the Boot Division and the Sole Division should negotiate a transfer price within the range of

$21 and $25 (cost from outside supplier).

4.3 The use of market price as a basis for transfer prices: If an external market price exists for transferred goods, profit centre managers will be aware of the price they could obtain or the price they would have to pay for their goods on the external market, and they would inevitably compare this price with the transfer price.

4.3.1 Example: Transferring goods at market value: A company has two profit centres, A and B. A sells half its output on the open market and transfers the other half to B. Costs and external revenues in an accounting period are as follows.

	A	B	Total
	$	$	$
External sales	8,000	24,000	32,000
Costs of production	12,000	10,000	22,000
Company profit			10,000

Required: What are the consequences of setting a transfer price at market value?

Solution: If the transfer price is at market price, A would be happy to sell the output to B for $8,000, which is what A would get by selling it externally instead of transferring it.

	A		B		Total
	$	$	$	$	$
Market sales		8,000		24,000	32,000
Transfer sales		8,000		-
		16,000		24,000
Transfer costs	-		8,000
Own costs	12,000		10,000		22,000
		12,000		18,000
Profit		4,000		6,000	10,000

The transfer sales of A are self-cancelling with the transfer cost of B, so that the total profits are unaffected by the transfer items. The transfer price simply spreads the total profit between A and B.

Consequences

(a) A earns the same profit on transfers as on external sales. B must pay a commercial price for transferred goods, and both divisions will have their profit measured in a fair way.

(b) A will be indifferent about selling externally or transferring goods to B because the profit is the same on both types of transaction. B can therefore ask for and obtain as many units as it wants from A.

A market-based transfer price therefore seems to be the ideal transfer price.

4.4   The merits of market value transfer prices

4.4.1 Divisional autonomy: In a decentralised company, divisional managers should have the autonomy to make output, selling and buying decisions which appear to be in the best interests of the division's performance. (If every division optimises its performance, the company as a whole must inevitably achieve optimal results.) Thus a transferor division should be given the freedom to sell output on the open market, rather than to transfer it within the company.

'Arm's length' transfer prices, which give profit centre managers the freedom to negotiate prices with other profit centres as though they were independent companies, will tend to result in a market-based transfer price.

4.4.2 Corporate profit maximisation: In most cases where the transfer price is at market price, internal transfers should be expected, because the buying division is likely to benefit from a better quality of service, greater flexibility and dependability of supply. Both divisions may benefit from cheaper costs of administration, selling and transport. Using a market price as the transfer price would therefore result in decisions which would be in the best interests of the company or group as a whole.

4.4.3 Divisional performance measurement: Where a market price exists, but the transfer price is a different amount (say, at standard cost plus), divisional managers will argue about the volume of internal transfers.

For example, if division X is expected to sell output to division Y at a transfer price of $8 per unit when the open market price is $10, its manager will decide to sell all output on the open market. The manager of division Y would resent the loss of their cheap supply from X, and would be reluctant to buy on the open market. A wasteful situation would arise where X sells on the open market at $10, where Y buys at $10, so that administration, selling and distribution costs would have been saved if X had sold directly to Y at $10, the market price.

4.5 The disadvantages of market value transfer prices: Market value as a transfer price does have certain disadvantages.

(a) The market price may be a temporary one, induced by adverse economic conditions or dumping, or it might depend on the volume of output supplied to the external market by the profit centre.

(b) A transfer price at market value might, under some circumstances, act as a disincentive to use up any spare capacity in the divisions. A price based on incremental cost, in contrast, might provide an incentive to use up the spare resources in order to provide a marginal contribution to profit.

(c) Many products do not have an equivalent market price so that the price of a similar, but not identical, product might have to be chosen. In such circumstances, the option to sell or buy on the open market does not really exist.

(d) There might be an imperfect external market for the transferred item so that, if the transferring division tried to sell more externally, it would have to reduce its selling price.

4.6 Cost-based approaches to transfer pricing: Problems arise with the use of cost-based transfer prices because one party or the other is liable to perceive them as unfair.

Cost-based approaches to transfer pricing are often used in practice, because in practice the following conditions are common.

(a) There is no external market for the product that is being transferred.

(b) Alternatively, although there is an external market, it is an imperfect one because the market price is affected by such factors as the amount that the company setting the transfer price supplies to it, or because there is only a limited external demand.

In either case there will not be a suitable market price on which to base the transfer price.

4.6.1 Transfer prices based on full cost: Under this approach, the full cost (including fixed overheads absorbed) incurred by the supplying division in making the 'intermediate' product is charged to the receiving division. The obvious drawback to this is that the division supplying the product makes no profit on its work so is not motivated to supply internally. In addition, there are a number of alternative ways in which fixed costs can be accounted for. If a full cost-plus approach is used, a profit margin is also included in this transfer price. The supplying division will therefore gain some profit at the expense of the buying division.

4.6.2 Example: Transfer prices based on full cost: Suppose a company has two profit centres, A and B. A can only sell half its maximum output of 800 units externally because of limited demand. It transfers the other half of its output to B which also faces limited demand. Costs and revenues in an accounting period are as follows.

	A $	B $	Total $
External sales	8,000	24,000	32,000
Costs of production in the division	13,000	10,000	23,000
Profit			9,000

Division A's costs included fixed production overheads of $4,800 and fixed selling and administration costs of $1,000.

There are no opening or closing inventories. It does not matter, for this illustration, whether marginal costing or absorption costing is used. For the moment, we shall ignore the question of whether the current output levels are profit maximising and congruent with the goals of the company as a whole.

If the transfer price is at full cost, A in our example would have 'sales' to B of $6,000 (($13,000 – 1,000) × 50%). Selling and administration costs are not included, as these are not incurred on the internal transfers. This would be a cost to B, as follows.

	A		B		Total
	$	$	$	$	$
Open market sales		8,000		24,000	32,000
Transfer sales		6,000		-
Total sales, inc transfers		14,000		24,000
Transfer costs	-		6,000
Own costs	13,000		10,000		23,000
Total costs, inc transfers		13,000		16,000
Profit		1,000		6,000	9,000

The transfer sales of A are self-cancelling with the transfer costs of B so that total profits are unaffected by the transfer items. The transfer price simply spreads the total profit of $9,000 between A and B.

The obvious drawback to the transfer price at cost is that A makes no profit on its work, and the manager of division A would much prefer to sell output on the open market to earn a profit, rather than transfer to B, regardless of whether or not transfers to B would be in the best interests of the company as a whole. Division A needs a profit on its transfers in order to be motivated to supply B; therefore transfer pricing at cost is inconsistent with the use of a profit centre accounting system.

An intermediate product is one that is used as a component of another product; for example, car headlights or food additives.

4.6.3 Transfer price at variable cost: A variable cost approach entails charging the variable cost (which we assume to be the same as the marginal cost) that has been incurred by the supplying division to the receiving division.

The problem is that with a transfer price at marginal cost the supplying division does not cover its fixed costs.

4.7 Identifying the optimal transfer price: Here are some guiding rules for identifying the optimal transfer price.

(a) The ideal transfer price should reflect the opportunity cost of sale to the supply division and the opportunity cost to the buying division. Unfortunately, full information about opportunity costs may not be easily obtainable in practice.

(b) Where a perfect external market price exists and unit variable costs and unit selling prices are constant, the opportunity cost of transfer will be external market price or external market price less savings in selling costs.

(c) In the absence of a perfect external market price for the transferred item, but where unit   variable costs are constant, and the sales price per unit of the end product is constant, the ideal transfer price should reflect the opportunity cost of the resources consumed by the supply division to make and supply the item and so should be at standard variable cost + opportunity cost of making the transfer.

(d) When unit variable costs and/or unit selling prices are not constant, there will be a profit- maximising level of output and the ideal transfer price will only be found by sensible negotiation and careful analysis.

(i) Establish the output and sales quantities that will optimise the profits of the company or group as a whole.

(ii) Establish the transfer price at which both profit centres would maximise their profits at this company-optimising output level.

There may be a range of prices within which both profit centres can agree on the output level that would maximise their individual profits and the profits of the company as a whole. Any price within the range would then be 'ideal'.

4.8   Transfer pricing calculations

4.8.1 Sub-optimal decisions: Note that, as the level of transfer price increases, its effect on a division within the organisation could lead to sub-optimalisation problems for the organisation as a whole.

4.8.2 Example: Sub-optimal decisions: For example, suppose division B could buy the product from an outside supplier for $10 instead of paying $15 ($6,000/ (800/2)) to division A. This transfer price would therefore force division B to buy the product externally at $10 per unit, although it could be manufactured internally for a variable cost of $(13,000 – 4,800 – 1,000)/800 = $9 per unit.

Although division B (the buying division) would save ($15 – $10) = $5 per unit by buying externally, the organisation as a whole would lose $400, as follows.

Per Unit	units
	$
Marginal cost of production	9
External purchase cost	10
Loss if buy in	1

The overall loss on transfer/purchase of 400 units is therefore 400 × $1 = $400.

This loss of $1 per unit assumes that any other use for the released capacity would produce a benefit of less than $400. If the 400 units could also be sold externally for $20 per unit, the optimal decision for the organisation as a whole would be to buy in the units for division B at $10 per unit.

                                                                                                                                          Per unit

                                                                                                                                                       $

Market price	20
Marginal cost	9
Contribution	11
Loss if buy-in	(1)
Incremental profit	10
The overall incremental profit would therefore be 400 ´ $10 = $4,000.

4.8.3 Example: Prices based on full cost plus: If the transfers are at cost plus a margin of, say, 10%, A's sales to B would be $6,600 ($13,000 – 1,000) × 50% × 1.10).

	A		B		Total
	$	$	$	$	$
Open market sales		8,000		24,000	32,000
Transfer sales		6,600		-
		14,600		24,000
Transfer costs	-		6,600
Own costs	13,000		10,000		23,000
		13,000		16,600
Profit		1,600		7,400	9,000

Compared to a transfer price at cost, A gains some profit at the expense of B. However, A makes a bigger profit on external sales in this case because the profit mark-up of 10% is less than the profit mark-up on open market sales. The choice of 10% as a profit mark-up was arbitrary and unrelated to external market conditions.

The transfer price fails on all three criteria (divisional autonomy, performance measurement and corporate profit measurement) for judgement.

(a) Arguably, the transfer price does not give A fair revenue or charge B a reasonable cost, and so their profit performance is distorted. It would certainly be unfair, for example, to compare A's profit with B's profit.

(b) Given this unfairness, it is likely that the autonomy of each of the divisional managers is under threat. If they cannot agree on what is a fair split of the external profit, a decision will have to be imposed from above.

(c) It would seem to give A an incentive to sell more goods externally and transfer less to B. This may or may not be in the best interests of the company as a whole.

In fact, we can demonstrate that the method is flawed from the point of view of corporate profit maximisation. Division A's total production costs of $12,000 include an element of fixed costs. Half of division A's total production costs are transferred to division B. However, from the point of view of division B, the cost is entirely variable.

The cost per unit to A is $15 ($12,000 800) and this includes a fixed element of $6 ($4,800 ÷ 800), while division B's own costs are $25 ($10,000 400) per unit, including a fixed element of $10 (say). The total variable cost is really $9 + $15 = $24, but from division B's point of view the variable cost is $15 + $(25 – 10) = $30. This means that division B will be unwilling to sell the final product for less than $30, whereas any price above $24 would make a contribution to overall costs. Thus, if external prices for the final product fall, B might be tempted to cease production.

4.8.4 Example: Transfer prices based on variable or marginal cost: A variable or marginal cost approach entails charging the variable cost (which we assume to be the same as the marginal cost) that has been incurred by the supplying division to the receiving division. As above, we shall suppose that A's cost per unit is $15, of which $6 is fixed and $9 variable.

	A		B		Company as a whole
	$	$	$	$	$	$
Market sales		8,000		24,000		32,000
Transfer sales		3,600		-
		11,600		24,000
Transfer costs	-		3,600
Own variable costs	7,200		6,000		13,200
Own fixed costs	5,800		4,000		9,800
Total costs and transfers		13,000		13,600		23,000
(Loss)/Profit		(1,400)		10,400		9,000

4.8.5 Divisional autonomy, divisional performance measurement and corporate profit maximisation

(a) This result is deeply unsatisfactory for the manager of division A who could make an additional

$4,400 ($(8,000 – 3,600)) profit if no goods were transferred to division B, but all were sold externally.

(b) Given that the manager of division A would prefer to transfer externally, head office are likely to have to insist that internal transfers are made.

(c) For the company overall, external transfers only would cause a large fall in profit, because division B could make no sales at all.

Point to note: Suppose no more than the current $8,000 could be earned from external sales and the production capacity used for production for internal transfer would remain idle if not used. Division A would be indifferent to the transfers at marginal cost, as they do not represent any benefit to the division.

If more than the $8,000 of revenue could be earned externally (i.e. division A could sell more externally than at present), division A would have a strong disincentive to supply B at marginal cost.