This document discusses objectives and methods for transfer pricing within companies. The key objectives are to provide information for cost-benefit tradeoffs, induce goal-aligned decisions, and measure economic performance simply. Methods include market prices, cost-based prices using standard or actual costs plus a markup, and negotiated prices. Ideal transfer pricing considers competence, open communication, market prices when available, and full information sharing, but constraints like limited markets or excess/short capacity complicate pricing.

1. Chapter 6
TRANSFER
PRICING

2. Objectives of Transfer Pricing
 Provide relevant information to
determine the optimum trade-off
between company costs & revenues.
 Induce goal congruent decisions.
 Help measure the economic
performance.
 Simple & easy.

3. Transfer Pricing Methods
Transfer price is the value placed on a
transfer goods or services in transactions
in which at least one of the two parties
involved is a profit center.

4. The Fundamental Principle
 The transfer price should be similar to the price that
would be charged if the product were sold to outside
customers or purchased from outside vendors.
 Two decisions are involved in designing a transfer
price system:
1. The sourcing decision: Should the company
produce the product inside the company or
purchase it from the outside vendor?
2. The transfer price decision: At what price should a
product be transferred between profit centers?

5. The Ideal Situation
 Competent People
 Good Atmosphere
 A Market Price
 Freedom to Source
 Full Information
 Negotiation

6. Constraints on Sourcing
 Limited Markets
1. The existence of internal capacity might limit the
development of external sales.
2. If the company is the sole producer of a
differentiated product, no outside source exists.
3. If a company has invested significantly in
facilities.
 Excess or Shortage of Industry Capacity

7. Cost-Based Transfer Prices
 If competitive price not available,
transfer prices may be set on the basis
of cost plus a profit.
 Two decisions must be made:
1. How to define cost.
2. How to calculate the profit markup.

8.  The Cost Basis
 The usual basis is standard cost.
 The Profit Markup
 Two decisions:
1. What the profit markup is based on.
2. The level of profit allowed.
 The profit markup base on:
 Percentage of costs
 Percentage of investment
 Base the profit allowance on the investment required
to meet the volume needed by the buying profit
centers.
Cost-Based Transfer Prices

9. Upstream Fixed Costs & Profits
 Agreement among business units.
 Two-Step Pricing
 Profit Sharing
 Two Sets of Prices

10. Pricing Corporate Services
 Exclude the cost of central service staff units
over which business units have no control
(e.g., central accounting, public relation,
administration).
 Control over amount of Service:
1. Standard variable cost.
2. Full cost: standard variable cost plus a fair share of
the standard fixed costs.
3. Market price: standard full cost plus a profit margin.
 Optional use of services.
 Simplicity of the price mechanism.

11. Administration of Transfer Prices
 Negotiation
 If headquarters control pricing, line’s
management’s ability to affect profitability is
reduced.
 Line management usually have the best
information on markets & costs.
 Arbitration & Conflict Resolution
 Assign to single executive
 Set up a committee