See Table 2. The following rules on transfer prices are necessary to get both parties to trade with one another:
For the transfer-out division, the transfer price must be greater than (or equal to) the marginal cost of production. This allows the transfer-out division to make a contribution (or at least not make a negative one). In Example 2, the transfer price must be no lower than $18. A transfer price of $19, for example, would not be as popular with Division A as would a transfer price of $50, but at least it offers the prospect of contribution, eventual break-even and profit.
For the transfer-in division, the transfer in price plus its own marginal costs must be no greater than the marginal revenue earned from outside sales. This allows that division to make a contribution (or at least not make a negative one). In Example 2, the transfer price must be no higher than $80 as:
$80 (transfer-in price) + $10 (own variable cost) = $90 (marginal revenue)
Usually, this rule is restated to say that the transfer price should be no greater than the net marginal revenue of the receiving division, where the net marginal revenue is marginal revenue less own marginal costs. Here, net marginal revenues = $80 = $90 – $10.
So, a transfer price of $50 (transfer price ≥ $18, ≤ $80), as set above, will work insofar as both parties will find it worth trading at that price.
The economic transfer price rule
The economic transfer price rule is as follows:
Minimum (fixed by transferring division)
Transfer price ≥ marginal cost of transfer‑out division
Maximum (fixed by receiving division)
Transfer price ≤ net marginal revenue of transfer‑in division
As well as permitting interdivisional trade to happen at all, this rule will also give the correct economic decision because if the final selling price is too low for the group to make a positive contribution, no operative transfer price is available.
So, in Example 2, if the final selling price were to fall to $25, the group could not make a contribution because $25 is less than the group’s total variable costs of $18 + $10. The transfer price that would make both divisions trade must be no less than $18 (for Division A) but no greater than $15 (net marginal revenue for Division B = $25 – $10), so clearly no workable transfer price is available.
If, however, the final selling price were to fall to $29, the group could make a $1 contribution per unit. A viable transfer price has to be at least $18 (for Division A) and no greater than $19 (net marginal revenue for Division B = $29 – $10). A transfer price of $18.50, say, would work fine.
Therefore, all that head office needs to do is to impose a transfer price within the appropriate range, confident that both divisions will choose to act in a way that maximises group profit. Head office therefore gives each division the impression of making autonomous decisions, but in reality each division has been manipulated into making the choices head office wants.
Note, however, that although we have established the range of transfer prices that would work correctly in terms of economic decision making, there is still plenty of scope for argument, distortion and dissatisfaction. Example 1 suggested a transfer price between $18 and $80, but exactly where the transfer price is set in that range vastly alters the perceived profitability and performance of each sub-unit. The higher the transfer price, the better Division A looks and the worse Division B looks (and vice versa).
In addition, a transfer price range as derived in Example 1 and 2 will often be dynamic. It will keep changing as both variable production costs and final selling prices change, and this can be difficult to manage. In practice, management would often prefer to have a simpler transfer price rule and a more stable transfer price – but this simplicity runs the risk of poorer decisions being made.
Practical approaches to transfer price fixing
In order to address these concerns, some common practical approaches to transfer price fixing exist:
1 Variable cost
A transfer price set equal to the variable cost of the transferring division produces very good economic decisions. If the transfer price is $18, Division B’s marginal costs would be $28 (each unit costs $18 to buy in then incurs another $10 of variable cost). The group’s marginal costs are also $28, so there will be goal congruence between Division B’s wish to maximise its profits and the group maximising its profits. If marginal revenue exceeds marginal costs for Division B, it will also do so for the group.
Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain drawbacks:
Division A will make a loss as its fixed costs cannot be covered. This is demotivating.
Performance measurement is distorted. Division A is condemned to making losses while Division B gets an easy ride as it is not charged enough to cover all costs of manufacture. This effect can also distort investment decisions made in each division. For example, Division B will enjoy inflated cash inflows.
There is little incentive for Division A to be efficient if all marginal costs are covered by the transfer price. Inefficiencies in Division A will be passed up to Division B. Therefore, if marginal cost is going to be used as a transfer price, at least make it standard marginal cost, so that efficiencies and inefficiencies stay within the divisions responsible for them.