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influence decisions.
The benefit of using a cost approach is that the company will invest effort into determining the actual costs
involved in making a product or providing another service. The selling division should be able to justify to the
purchasing division the cost that will be charged, which likely includes a profit margin, based on what the
division would earn on a sale to an outside customer. At the same time, a deeper understanding of what drives
the costs within a division provides an opportunity to identify activities that add unnecessary costs. Companies
can, in turn, work to increase efficiency and eliminate unnecessary activity and bring down the cost. In
essence, the selling division has to justify the costs it is charging the purchasing division.
Negotiated Price Approach
Somewhere in between a transfer price based on cost and one based on market is a negotiated price
approach in which the company allows the buying segment and the selling segment to negotiate the transfer
price. This is common in situations in which there is no external market. When an external price exists and is
used as a starting point for establishing the transfer price, the organization must be aware of differences in
specific costs between the source of the external price and its own organization. For example, a price from an
external source may include a higher profit margin than the profit margin targeted by a company pursuing a
cost leadership strategy. In this case, the external price should be reduced to account for such differences.
However, one disadvantage of using a negotiated price system is the possibility of creating a situation in which
competition exists between a department and an outside vendor (as occurs when it is cheaper for a
department to purchase from an outside vendor rather than another department in the organization) or,
worse yet, between departments of the same organization. It is paramount that, when selecting a transfer
pricing methodology, the goals of the particular departments involved align with the overall strategic goals of
the organization. A transfer pricing structure is not intended to facilitate competition between departments
within the same company. Rather, a transfer pricing system should be viewed as a tool to help the company
remain competitive in the marketplace and improve a company’s overall profit margin.
Other Transfer Pricing Issues
The three approaches to transfer pricing assume that the selling department has excess capacity to produce
additional products to sell internally. What happens if the selling department does not have excess
capacity—in other words, if the selling department can sell all that it produces to external customers? If an
internal department wants to purchase goods from the selling department, what would be an appropriate
selling price? In this case, the transfer price must take into consideration the opportunity cost of the
contribution margin that would be lost from having to forego external sales in order to meet internal sales.
Suppose in the previous example that the blending department is at full capacity but the bottling department
wants to purchase some of its soft drink blends internally. Assume the variable cost to produce one unit of soft
drink is $10, the fixed cost per unit is $2, and the market price for selling one unit is $18. What would be an
appropriate transfer price in this situation? Since the blending department does not have the capacity to meet
external sales plus internal sales, in order to accept the internal sales order, the blending department would
have to lose sales to external customers. The contribution margin per unit is $8 ($18 − $10). Thus, $8 per unit
would be given up for each external unit that is sold internally.
Looking only at costs, the blending department would be indifferent between an external sale of $18 and an
internal sale of $18 ($10 variable cost + $8 contribution margin). Obviously, there are other issues that need to
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be considered in these situations, such as the effect on external customers if demand cannot be met. Overall,
if there is no excess capacity, the transfer price should take into consideration the opportunity cost lost from
taking internal sales over external sales.
In addition to the possibility of losing opportunity costs, there are additional transfer pricing issues. Recall that
decentralized organizations delegate decision-making authority throughout the organization. A well-designed
transfer pricing policy can contribute not only to the segment manager’s profits but to overall corporate
profits in situations where the transfer price is lower than the external price. However, when a transfer pricing
system is used to facilitate transactions between departments, an ill-designed policy is likely to lead to
disputes between departments. It is possible the departments view each other as competition rather than
strategic partners. When this occurs, it is important for upper-level management to establish a process that
allows managers to resolve disagreements in a way that aligns with organizational, rather than departmental,
goals.
Transfer pricing systems become even more complicated when departments are located in different countries.
The transfer price in an international setting must also account for differences in currencies and fluctuating
exchange rate as well as differences in regulations such as tariffs and duties, taxes, and other regulations.
Transfer Pricing Example
Regal Paper has two divisions. The Paper Division produces copy paper, wrapping paper, and paper used on
the outside of cardboard displays placed in grocery, office, and department stores. The Box Division produces
cardboard boxes sold at Christmas, cardboard boxes purchased by manufacturers for packaging their goods,
and cardboard displays for stores, particularly seasonal displays. Both divisions are profit centers, and each
manager is evaluated and rewarded based on his division’s profitability. The Box Division has approached the
Paper Division to buy paper needed to cover cardboard displays that have been ordered by several major
snack food manufacturers for the upcoming Superbowl game. The Box Division has been buying the display
coverings from an external seller for $12.50 per unit. Currently, the Paper Division has excess capacity and can
fill the order for the 500,000 display coverings that the Box Division is requesting.
The cost to the Paper Division to produce one display covering is as follows:
What would be the transfer price per unit under each of the following scenarios?
1. Market-based transfer price. This transfer price is the same as the selling price to external customers,
which is $12.
2. Cost-based transfer price. This transfer price is the same as the variable costs per unit, which is $8.
3. Full-cost–based transfer price. This transfer price is the same as the variable costs plus the fixed cost per
unit, which is $9.
4. Cost plus assuming 20% mark-up. This marks up the cost-based transfer price by 20%, which is $8 × 120%,
or $9.60.
5. Full-cost plus assuming 20% mark-up. This marks up the full-cost–based transfer price by 20%, which is $9
× 120%, or $10.80.
6. Range of negotiated transfer price. The negotiated transfer price should be between the lowest and
highest possible prices: $8–12
Chapter 9 Responsibility Accounting and Decentralization 487
7. What if Paper had no excess capacity? If the Paper Division had no excess capacity, the transfer price
would be the cost plus the contribution margin, which is $8 + $4, or $12.
8. Which transfer price is best? If there is excess capacity, then typically a negotiated transfer price is best,
as it allows the managers who are evaluated on that decision to have input into the decision and does not
take away their autonomy. Table 9.1 shows the per-unit effect on incomeof each of the transfer pricing
options on each division. Remember, the effects provided here cannot necessarily be generalized, as
there are two critical factors: whether or not the selling department is at capacity and the price at which
the purchasing department could buy the goods externally, which in this case is $0.50 more per unit than
the market price of the paper being sold by the Paper Division.
Per-Unit Effect on Division Income of Various Transfer Pricing Methodologies
Transfer Pricing
Method
Paper Division Box Division
Market $4 per unit increase in income
($12 SP − $8 VC)
$0.50 per unit increase in income
($12.50 − $12 SP)
Cost $0 per unit increase in income
($8 SP − $8 VC)
$4.50 per unit increase in income
($12.50 − $8)
Full-cost $1 per unit increase in income
($9 SP − $8 VC)
$3.50 per unit increase in income
($12.50 − $9)
Cost-Plus (20%) $1.60 per unit increase in income
($9.60 SP − $8 VC)
$2.90 per unit increase in income
($12.50 − $9.60)
Full-cost Plus (20%) $2.80 per unit increase in income
($10.80 SP − $8VC)
$1.70 per unit increase in income
($12.50 − $10.80)
Negotiated ($0 − $12) Increase to income between $0 and $4
per unit
Increase to income between $0.50
and $4.50
No Excess Capacity $4 per unit increase in income
($12 SP − $8 VC)
$0.50 per unit increase in income
($12.50 − $12 SP)
SP = selling price; VC = variable cost
Table 9.1
As you can see, the transfer price can significantly affect the profitability of the division. It is easy to see which
transfer prices most benefit the seller and which most benefit the buyer. Thus, as previously mentioned, a
negotiated transfer price is often the best resolution to determining a transfer price.
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T H I N K I T T H R O U G H
Comparing Transfer Pricing and Outsourcing
Assume you are the President of a manufacturing firm that has a division that transfers products to
other divisions within the company. The other divisions have recently complained that the transfer price
charged to the departments has increased significantly over the past several quarters. They are
frustrated because performance evaluations and bonuses are linked to the profitability of their
respective departments.
During a recent management meeting, a cost accountant suggests the company can solve this issue by
transferring production to another supplier that has a lower cost of production due to lower labor costs.
In addition to solving the conflict between departments, the company’s overall profitability will increase
because of the substantial cost savings.
Evaluate this scenario and explain how you would respond as the company’s President. Consider the
perspectives of various stakeholders in this situation.
Chapter 9 Responsibility Accounting and Decentralization 489
allocated costs
centralization
controllable costs
cost approach
cost center
decentralization
discretionary cost center
goal congruence
investment center
lower-level management
management control system
market price approach
mid-level management
negotiated price approach
organizational chart
profit center
residual income (RI)
responsibility accounting
responsibility centers
return on investment (ROI)
revenue center
segment
Key Terms
costs that are generated by non–revenue generating portions of the business, such as
corporate headquarters, that are assigned based on some formula to the revenue generating portions of
the business
business structure in which one individual makes the important decisions and provides the
primary strategic direction for the company
those that a company or manager can influence
transfer pricing structure in which the transfer price may be based on total variable cost, full
cost, or a cost-plus scenario, calculated by adding a markup to either variable cost or full cost
organizational segment in which a manager is held responsible only for costs
business structure in which the decision-making is made at various levels of the
organization
organizational segment in which a manager is held responsible only for
controllable costs when there is not a well-defined relationship between the center’s costs and its services
or products
integration of multiple goals, either within an organization or across multiple components
or entities; congruence is achieved by aligning goals to achieve an anticipated mission
organizational segment in which a manager is accountable for profits (revenues minus
expenses) and the invested capital used by the segment
level of management that provides basic supervision and oversight for the
operations of the organization
structure within an organization that allows managers to establish,
implement, and monitor progress toward the strategic goals of the organization
transfer pricing structure in which the transfer price is based on the price the seller
would use for an outside customer
level of management that receives direction from upper management and
supervises and provides direction to lower-level management
transfer pricing structure in which the transfer price is based on negotiations
between the buying segment and the selling segment
graphical representations illustrating the authority for decision-making and oversight
throughout an organization
organizational segment in which a manager is responsible for and evaluted on both revenues
and costs
amount of income a given division (or project) is expected to earn in excess of a firm’s
minimum return goal
method of encouraging goal congruence by setting and communicating the
financial performance measures by which managers will be evaluated
segments in which supervisors or managers have responsibility for the performance
of the center and the authority to make decisions that affect the center
measure of the percentage of income generated by profits that were invested
in capital assets
part of an organization in which management is evaluated based on the ability to generate
revenues; the manager's primary control is only revenues
portion of the business that management believes has sufficient similarities in product lines,
490 Chapter 9 Responsibility Accounting and Decentralization
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	Chapter 9. Responsibility Accounting and Decentralization
	Glossary