Managerial Accounting — Transfer Pricing: Pricing Transactions Between Divisions
When a components division passes parts to a finished-goods division, no money changes hands for the company as a whole. But if the two divisions are evaluated as the profit or investment centers of chapter 5, the parts must carry an internal price. That price is the transfer price. A transfer price does not change total company profit, but it changes which division the profit lands in and what decisions the divisions make.
1. The objectives of transfer pricing
A good transfer price should satisfy three things.
- Goal congruence: decisions a division makes in its own interest also benefit the company as a whole.
- Fair performance evaluation: it reflects each division’s performance fairly.
- Autonomy: divisions can decide for themselves whether to buy and sell.
It is hard to satisfy all three with a single price.
2. Methods of setting transfer prices
| Method | Description | Strengths | Problems |
|---|---|---|---|
| Market-based | The price in the external market | Objective; evaluates the selling division fairly | Unusable without a competitive market |
| Variable cost | The selling division's variable cost | Matches the company optimum when there is idle capacity | Selling division earns zero or less |
| Full cost (cost-plus) | Full cost, or cost plus a markup | Easy to calculate and widely used | Fixed costs look variable to the buying division and prompt wrong decisions |
| Negotiated | The two divisions negotiate | Respects autonomy | Depends on bargaining power; time-consuming |
3. Minimum and maximum transfer prices
The minimum transfer price the selling division can accept is:
The buying division’s maximum transfer price is the price at which it can buy the same part outside (or, if none, the net benefit from using the part). If the minimum ≤ the maximum, the internal transaction benefits the company, and any price within that range leaves total company profit unchanged.
A. Worked example
Components division S sells its part externally for ₩100,000 per unit. Variable cost is ₩60,000 per unit. Finished-goods division B can buy 1,000 of these parts from an outside supplier at ₩95,000 each.
| Situation | S's minimum transfer price | B's maximum transfer price | Conclusion |
|---|---|---|---|
| S has enough idle capacity | 6 + 0 = 6 | 9.5 | Trade internally between 6 and 9.5; company profit rises by 3.5 per unit |
| S at full capacity (selling everything outside) | 6 + (10 − 6) = 10 | 9.5 | No internal trade; B buys outside |
At full capacity, every unit S passes to B costs it ₩40,000 of contribution margin on external sales. If B can buy outside at ₩95,000, the company as a whole is ₩5,000 per unit better off with S selling outside at ₩100,000 and B buying at ₩95,000.
4. The trap of cost-based prices
Suppose S has idle capacity but the transfer price is set on full cost at ₩105,000 per unit (variable 6 + allocated fixed 3 + markup 1.5, in ₩10,000). B finds the outside price of ₩95,000 cheaper and buys outside. For the company as a whole, a part that could be made at a variable cost of ₩60,000 is bought for ₩95,000, losing ₩35,000 per unit — ₩35 million for 1,000 units. When fixed costs are mixed into the transfer price, they look like variable costs to the buying division and lead to decisions that hurt the company. Dual pricing (S records revenue at market price, B records cost at variable cost) is sometimes used to fix this, but then the sum of divisional profits exceeds company profit.
5. International transfer pricing and tax
When corporate tax rates differ between countries, transfer prices create an incentive to shift profit to low-tax countries. So each country’s tax law requires international transactions between related parties to use an arm’s length price (the price at which independent third parties would have transacted). In Korea, the Adjustment of International Taxes Act sets out the methods for determining the arm’s length price (comparable uncontrolled price, resale price, cost plus, transactional net margin, profit split and others), and the tax authorities adjust income if a price departs from it. The OECD Transfer Pricing Guidelines are the international benchmark.
Check your understanding
Division S’s part has a variable cost of ₩40,000 per unit and an external selling price of ₩70,000 per unit. S can make 10,000 units a year and external demand is 8,000 units. Division B requests 3,000 units and can buy them outside at ₩65,000 each. What is the minimum transfer price S will accept?
Idle capacity is 2,000 units. Those 2,000 carry no opportunity cost, so their minimum transfer price is ₩40,000. The remaining 1,000 require giving up external sales and carry an opportunity cost of ₩30,000 per unit, for ₩70,000. The minimum transfer price across all 3,000 units averages (₩50,000). That is below B’s maximum of ₩65,000, so a deal is possible. For the company as a whole, however, buying the last 1,000 outside at ₩65,000 (while S sells them outside at ₩70,000) is ₩5,000 per unit better, so the optimum is to trade only 2,000 units internally.
References
- Charles Horngren, Srikant Datar and Madhav Rajan, Cost Accounting: A Managerial Emphasis, ch. 22
- Adjustment of International Taxes Act, Article 8 (methods for determining the arm’s length price) — Korea Law Information Center
- OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2022)
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