CONTEMPORARY ISSUES: DIVISIONAL PERFORMANCE

MEASUREMENT IN RESPONSIBILITY ACCOUNTING –

TRANSFER PRICING

Dr Manisha Bhavsar

INTRODUCTION

An organization may be divided into a number of divisions, and the performance of

each division can be measured in terms of both the income earned and the costs
incurred. In decentralized organizations, very often goods/services which are outputs
of one division may be transferred to another division as inputs at a “transfer price”.
When each decentralized division is deemed to be a profit center, and transfer of
goods/services amongst the independent profit centers takes place, divisional
performance evaluation will be influenced by the transfer price. In this module, we shall
understand transfer pricing as a measure for divisional performance.

CONCEPT OF TRANSFER PRICING AND TRANSFER PRICE

Transfer pricing is the set of rules an organization uses to allocate jointly earned
revenue among responsibility centers. These rules can be arbitrary when a high
degree of interaction exists among the individual responsibility centers. When any
product or service is transferred between any two departments in the same
organization, the values of the internal transfers will be determined by these rules, and
the organization’s jointly earned revenues will be allocated to the individual profit
centers, and will therefore affect each center’s reported profit. Thus, transfer pricing is
the pricing of internal transfer of goods and services between profit centers of an
organization.

A transfer price is the price one sub-unit (segment, department, division, etc.) charges
for a product or service supplied to another sub-unit of the same organization. The
transfer price creates revenue for the selling sub-unit and a purchase cost for the
buying sub-unit, thus affecting operating incomes. It can be used to evaluate the
performance of each sub-unit and to motivate managers. Ideally, the transfer prices

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should promote goal congruence between the profit center goal and the corporate
goal, enable effective performance appraisal, maintain divisional autonomy and also
promote internal transfers rather than buying from outside.

CIMA Official Terminology has defined transfer price as “the price at which goods or
services are transferred between different units of the same company. If those units
are located within different countries, the term International Transfer Pricing is used.
The extent to which the transfer price covers costs and contributes to profit is a matter
of policy. A transfer price may, for example, be based upon marginal cost, full cost,
market price or negotiation. Where the transferred products cross national boundaries,
the transfer prices used may have to be agreed with the governments of the countries
concerned.”

OBJECTIVES OF TRANSFER PRICING SYSTEM

Transfer pricing is of particular importance in an organization as it improves decision

making in a decentralized organization. The objectives of a transfer pricing system are
given below.
1. To foster a commercial attitude in those who are responsible for the performance
of profit centers. The emphasis is on improving the profitability position of the units.
2. To optimize the profit of the company over a given short period of time. The
emphasis is on maximum utilization of the plant capacity.
3. To provide each sub-unit with relevant information that motivates divisional
managers to make optimal decisions which will improve the divisional profits and
ultimately the profits of the company as a whole.
4. To promote goal congruence, i.e. actions by divisional managers to improve profits
should automatically improve company profits.
5. To optimize the allocation of companies’ financial resources. The allocation of
resources is based on relative performance of various profit centers, which in turn
are influenced by transfer pricing policies.
6. To enable divisional performance evaluation by compensating a division for
benefits provided to other divisions and by charging it for benefits received from
other divisions.

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7. To motivate divisional managers to retain autonomy, and to maximize the
profitability of their divisions while acting in the best interest of the organization as
a whole.
8. To estimate accurate earnings on proposed investment decisions.
9. To assist in decision making related to make or buy, sell a product or process it
further, or choosing between alternative production methods.
10. To ensure minimum intervention by top management.
11. To minimize overall tax burden in case of international transfer pricing.

REQUISITES OF A SOUND TRANSFER PRICING SYSTEM

1. A transfer pricing system should be simple to understand and easy to operate.

2. The system should provide adequate measures of profit for the division to ensure
motivation for the divisional manager and his team.
3. The transfer pricing should be goal congruent, and should help to avoid
dysfunctional decision-making.
4. The system should provide adequate information to senior management to be used
for decision-making and divisional performance evaluation.
5. The system should enable fixation of fair transfer prices for the output transferred
or service rendered. These transfer prices should be reviewed periodically as per
changes in the demand and supply conditions in the market.
6. A transfer pricing system should foster a healthy inter-departmental competitive
spirit without needless arguments. Prolonged arguments between divisions should
be discouraged.
7. The division should have free access to various sources of market information, and
the divisional manager should be given autonomy and freedom to sell in the open
market.
8. There should be a negotiation for transfer prices between the divisional managers
of the selling division and the buying division, and these negotiations should be
guided by pre-determined rules.
9. There should be a well-laid down system of arbitration to resolve the differences,
instead of having the need to seek the intervention of higher management time and
again involving wastage of resources.

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10. When transfer prices are based on market prices, long term competitive and
normal prices should be considered.
11. Transfer pricing and arbitration ground rules should be reviewed periodically
depending on changes in business conditions.

BENEFITS OF A TRANSFER PRICING SYSTEM

1. It makes divisional performance evaluation easier.

2. It develops healthy inter-divisional competitive spirit.
3. It makes “Management by Exception” possible.
4. It promotes goal congruence, and helps in coordination of divisional objectives in
achieving organizational goals.
5. It provides useful information to the top management in making policy decisions
like expansion, subcontracting, closing down of a division, make or buy decisions,
etc.
6. It acts as a check on supplier’s prices.
7. It fosters economic entity and free enterprises system.
8. It helps in self advancement, generates high productivity and encouragement to
meet the competitive economy.
9. It optimizes the allocation of company’s financial resources based on the relative
performance of various profit centers, which in turn are influenced by transfer
pricing policies.

NECESSITY OF A TRANSFER PRICING SYSTEM

Transfer pricing policies are important in organizations which have

1. High volumes of inter-divisional sales: In a vertically integrated company, each
division in succession may produce a component that is a necessary part of the
product being created by the next division in line. Any incorrect transfer pricing
under this scenario can cause considerable dysfunctional behaviour.
2. High volumes of segment-specific sales: Even if a company as a whole does
not transfer much products between its divisions, specific divisions or product lines
within each division do depend on the accuracy of transfer pricing for selected
products.
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3. High degree of organizational decentralization: When various divisions of the
company are expected to operate as independently as possible, they are not
motivated to work together unless the transfer prices used are set at levels that
give them an economic incentive to do so.

DIFFICULTIES IN A TRANSFER PRICING SYSTEM

1. An inefficient transfer pricing system can lead to sub-optimal decisions, which may
lead to inherent losses of significant propositions. The transfer pricing policy,
therefore, should promote goal congruence and motivate divisional managers to
take actions such that they not only improve divisional profits, but also the company
profits.
2. An error in transfer pricing may have considerable impact on divisional profits and
morale of the concerned divisional manager and his team. Hence, the transfer price
should represent a fair value of goods/services being provided, as it will affect the
divisional performance evaluation.
3. An imposed unfair transfer price can lead to behavioural problems, resentment,
hostility and loss of motivation, thus nullifying the benefits of a decentralized
divisional structure. Efforts should be made to avoid behavioural problems by use
of such a system which lends sufficient opportunity for fair arguments leading to
acceptable decisions in the available structure.
4. A bad transfer pricing policy can give rise to inter-divisional conflicts, which can be
expensive in terms of loss of resources and time taken in arbitration between the
divisions. The problem can be mitigated by including through foresightedness,
clear instructions in the system relating to different situations, which may arise
between the transferor division and the transferee division.

TRANSFER PRICING METHODS

The methods of pricing usually employed in industry where goods/services are
transferred from one unit to another can be broadly classified under three categories.
• Cost-based transfer pricing
• Market-based transfer pricing
• Negotiated transfer pricing

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However, two other methods of transfer pricing are
• Dual Transfer Pricing
• Opportunity Cost-based Transfer Pricing

(A) COST-BASED TRANSFER PRICING

The top management may choose a transfer price based on costs of producing the
product in question. This is especially helpful when market prices are unavailable,
inappropriate, or too costly to obtain, for example, when the product may be
specialized, or when the internal product may be different from the products available
externally in terms of quality and customer service. The variants for such cost-based
transfer pricing are given below.
1. Actual Cost of Production: This is the simplest method of transfer pricing in which
the transfer price is determined on the basis of the cost of production arrived as in
the traditional method of valuation of inventory. The purpose is to meet the demand
of the user unit. Under this method, it is difficult to measure the performance of
each profit center. Hence, it is used where the responsibility for profit performance
is centralized.
2. Variable/Marginal Cost: The transfer price is determined on the basis of the
variable or marginal cost. This method is particularly useful when the capacity of
the selling unit is idle. Adoption of variable cost for transfer pricing will lead to full
utilization of capacity. This method is used when improving overall profitability of
the company is the main objective. However, it is difficult to calculate the variable/
marginal cost due to unavailability of precise information. Moreover, the selling unit
will be reluctant as there is no incentive to produce additional units.
3. Full Cost: The transfer price is inclusive of not only the actual cost of production,
but also the expenses incurred towards administration, selling and distribution by
the selling unit. The selling unit thereby can recover full cost of the goods
transferred. However, measurement of divisional profit is not possible under this
method.
4. Full Cost plus Mark-up: The transfer price charged by the selling unit comprises
of the full cost of sales plus some mark-up or an allowance for profit. This allowance
is either expressed as a percentage of capital employed or cost of sales. Under

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 this method, profit performance of each unit is measurable and the efficiency can
be reasonably determined. However, the profit margin added is decided on an
arbitrary basis. At times, the user unit is penalized for the inefficiency of the selling
unit by way of high transfer price.
5. Standard Cost: The transfer price is based on a standard cost, which is pre-
determined based on scientific analysis and management’s view of efficient
operations and relevant expenditure. The variances from standard cost are
normally absorbed by the selling unit, but sometimes transferred to the user unit.
Inventories are carried both by the selling unit and the user unit at standard cost.
Once the standards are properly set, operation of this system is simple. However,
the responsibility of profit performance is centralized. It is not possible to measure
the profit performance of each unit.
6. Standard Cost plus Lump Sum: The goods/services are transferred from the
selling unit to the buying unit at standard variable costs. In addition, a pre-
determined lump sum charge towards fixed costs plus a lump sum profit is added
back to the revenues of the selling unit on a monthly or annual basis. This lump
sum amount is calculated based on expected long-run transactions between the
two units.

(B) MARKET-BASED TRANSFER PRICING

The top management may choose to use as the transfer price, the market price of a
similar product or service prevailing in a competitive market, or the external price that
a sub-unit charges to outside customers. The market price is not significantly affected
by the unilateral action of any one buyer or seller. The normal market price is
determined by the forces of demand and supply in the long run. Any profit resulting in
this method, therefore, is a good measure of overall efficiency of various units. Thus,
market-based transfer price acts as a good incentive for efficient production to the
selling unit, and any inefficiency in production and excessive cost will not be passed
on to the user unit. Competitive market prices also provide a reliable measure of
divisional income as they are established independently.

However, the main difficulty in this method is the identification of an appropriate market
price, because it is possible that the prices in the open market vary between suppliers
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due to special or quantity discounts offered, extent of after sales services provided,
delivery expenses charged, or even due to distress pricing by sellers who have an
inventory pile-up.

Advantages of Market-based Transfer Pricing

1. Market price truly represents opportunity costs.
2. Actual historical costs fluctuate from time to time and are not readily available,
whereas market prices are easily available.
3. The current performance of both the selling and the user units can be assessed in
the light of currently existing conditions.
4. Variances between current and predicted prices provide useful control data.

Limitations of Market-based Transfer Pricing

1. The market price fails to become opportunity cost when the company is the price
leader or a monopolist.
2. There could be different interpretations of the term ‘market price’, viz. ex-factory
price, wholesale price, consumer price, etc.
3. Market price includes selling and distribution costs also, which are not incurred at
all in inter-unit transfers, and so market price will not be a satisfactory measure in
fixing transfer price.
4. When the production is for captive consumption, or when no market price prevails
for intermediate and semi-finished products, it would be difficult to fix the transfer
price. If the price is fixed based on market reports, it may be inaccurate.
5. Market information may not be readily available at times, and so additional costs
may have to be incurred to obtain such information.
6. When market price fluctuates from time to time or during inflationary times, the
market price would not be a good basis to fix transfer price due to frequent changes
in the price.

(C) NEGOTIATED TRANSFER PRICING

The sub-units of a company are free to negotiate the transfer price between
themselves, and then decide whether to buy and sell internally or to deal with outside
parties. Sub-units may use information about costs and market prices in these
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negotiations, but it is not necessary that the chosen transfer price bear any specific
relationship to either cost or market price data. Negotiated transfer prices are often
employed when market prices are volatile and change occurs constantly. The
negotiated transfer price is the outcome of a bargaining process between the selling
and the buying unit.

Under this method, the divisional managers involved act much like managers of
independent companies negotiating deals with outsiders. The divisional managers
have the freedom to negotiate or bargain to determine a competitive transfer price, so
that none of them has an undue advantage over the other. They also have the freedom
to go outside if the internal transfer price is not acceptable to them. Especially when
the market prices are lower, the user/buying unit may be tempted to purchase from
outside, and when the market prices are higher, the selling unit may be tempted to sell
outside. This may affect the overall profitability of the organization. However, the top
management may impose restrictions on the external purchase/sale, in order to avoid
any reduction in the overall profit of the company.

Limitations of Negotiated Transfer Pricing

1. A system of negotiated transfer prices develops a business-like attitude amongst
various divisions of a company. This attitude may tempt the divisional managers to
sell their output to outside parties or purchase their requirements from outside
sources, even by ignoring the overall interest of the company.
2. Agreed transfer price between divisions of a company depends on the negotiating
skills and bargaining power of the managers involved. This may lead to incorrect
fixation of transfer price, and will distort the divisional performance of the weak
manager.
3. Negotiating the transfer price is a time-consuming exercise for the divisional
managers involved and requires both divisions to spend a lot of resources.
Moreover, negotiations may be affected by personal biases or access to
confidential information.
4. Negotiations may lead to conflicts between the divisions of a company, and
resolution of such disputes may require a lot of time and efforts of the top
management.

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(D) DUAL TRANSFER PRICING

There is seldom a single transfer price that simultaneously meets the criteria of goal
congruence, management effort, divisional performance evaluation and divisional
autonomy. As a result, companies may choose to use a dual transfer pricing
arrangement, which may provide for different transfer prices for the selling and the
buying units. The selling unit may be allowed to record the transfer of goods/services
at one price, say the market price, whereas the buying unit may record the transfer at
another price, say a cost-based price.

Such an arrangement provides a profit margin on the goods transferred for the selling
unit, thus helping in divisional performance measurement. At the same time, it results
into a minimal cost for the buying unit, thereby helping in decision-making. Dual
transfer pricing, thus, eliminates the problem of having to artificially divide the profits
between the selling and the buying units, and allows managers to have the most
relevant information for decision making and performance evaluation. However, an
internal reconciliation is needed to adjust revenues and costs when company financial
statements are prepared. Dual transfer pricing is, however, not widely used in practice
as it creates confusion for both the selling and the buying units.

(E) OPPORTUNITY COST-BASED TRANSFER PRICING

The opportunity cost-based transfer pricing recognizes the minimum price that a
selling unit would be willing to accept and the maximum price that a buying unit would
be willing to pay. These minimum and maximum prices correspond to the opportunity
cost of transferring goods/services internally within the organization. The opportunity
cost-based transfer price is ideal for the conditions when the selling unit cannot sell
and the buying unit cannot buy at perfectly competitive prices.

For a selling division, the opportunity cost of transfer is greater of the following:
• Market price of the transferred product for an outside sale
• Differential production cost of the transferred product

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For a buying division, the opportunity cost of transfer price is lesser of the following:
• Purchase price required to be paid if it is purchased from the open market
• Profit that would be lost from the final product if the transferred unit could not
be obtained at an economic price

A transfer price is in the best economic interest of the company if the opportunity cost
for the selling division is less than the opportunity cost for the buying division. A
transfer will be encouraged as long as the transfer price is greater than the opportunity
cost of the selling division and less than the opportunity cost of the buying division.

GENERAL RULE IN FIXATION OF A TRANSFER PRICE

As a first step, the general rule for fixing transfer prices such that the buying division
makes the economic decisions that are optimal from the viewpoint of the total company
is to transfer goods/services from a selling division to a buying division at

Marginal / Incremental Cost to the Selling Division +

Implicit Opportunity Cost to the Organization if goods are transferred internally

This is the price that would usually make the selling division indifferent as to whether
the output is sold internally or externally. The profit of the selling division would be
same under either alternative.

GENERAL CONFLICTS IN TRANSFER PRICING AND RESOLVING THE

CONFLICTS

The criteria for fixing transfer prices are

• Goal congruence in decision making
• Management efforts
• Divisional performance evaluation
• Divisional autonomy and motivation

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However, there is seldom a single transfer price that simultaneously meets all the
criteria. They often conflict and divisional managers are forced to make trade-offs. If
divisional managers are given absolute freedom to decide the transfer price, there is
a possibility that divisional goals may be pursued, ignoring overall company interests.
This may force the top management to interfere in divisional decision making, and
dictate or impose a transfer price. This may result into conflicts between a division and
the company as a whole, because divisional autonomy and performance evaluation is
ignored.

In order to resolve the transfer pricing conflicts, dual transfer pricing can be used. The
transfer price should be fixed carefully so as not to benefit one division at the cost of
the other. Transfer prices should not act as a disincentive to the divisional managers
concerned, because they will have an effect on the motivation of the division and on
the overall profitability of the organization.

INTERNATIONAL TRANSFER PRICING

Transfer pricing is used by MNCs to price inter-corporate exchange of goods, services,

technology and capital, in a manner designed to maximize overall after-tax profit.
These products and factor flows range from intermediate and finished goods to less
tangible items such as management skills, trademarks and patents. When such
transfers take place across national frontiers, new considerations which can have a
major impact on total corporate profit, arise. Some of them are given below.

1. Financial Aspects: The transfer price between nations can be manipulated to

minimize tax or minimize import duty liability or transfer funds. For example,
transferring products into high duty countries at artificially low prices to pay low
duties, transferring products into high tax countries at high transfer prices to
eliminate profits there and thereby transfer profits to low tax countries, etc.
2. Strategic Aspects: International transfer pricing can also be used as a weapon in
the overall marketing strategy; profit can be concentrated, by vertically integrated
corporations, at the stage of production where there is least competition.
Competitors operating at other stages of production can thus be discouraged by
the relatively low profits to be earned.
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3. Government Attitudes: Manipulating international transfer prices clearly offers
the prospect of very significant financial gain. Such manipulations have attracted
the attention of governments. For example, the government of the exporting
country will try to ensure that the transfer price is not artificially low, and that
appropriate profits are shown and taxes are paid accordingly. On the other hand,
in the importing country, tax authorities will ensure that transfer prices are not
unreasonably high so as to reduce local profits and consequently the tax liability.
4. Company Attitudes: It is not clear whether the financial and strategic aims of
international transfer pricing are reconcilable with the initial aim of good corporate
management.

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