Different Types of Transfer Pricing Methods

For each of the under-noted transfer pricing methods, discuss the market conditions appropriate for their adoption and their limitations.

(i) Market-based transfer prices
(ii) Full-cost based transfer prices
(iii) Negotiated transfer prices
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Market-based Transfer Price

Market conditions which are appropriate for adoption
• Are generally appropriate in a perfect market, where there is homogeneous product with only one price for both sellers and buyers and no buying or selling costs.
• In a perfect market, Selling Division (SD) will be operating at full capacity and can sell whatever quantity of intermediate product it can produce in the external market. In this situation, internal transfers will result in a need to sacrifice external sales. The benefit forgone that is the contribution lost (opportunity cost) from sacrificing external sales should be included in the transfer price. Thus in this situation TP=MP will be consistent with the general TP rule.

• TP=MC+OC = MP

• In a perfect market, the minimum TP is also the maximum TP. Thus, both SD and BD will be happy with a transfer price set as the market price.
• The adoption of market-based transfer price in a perfectly competitive market meet the criteria of a good transfer price, that is it will promote goal congruent decisions, preserve divisional autonomy and provide an equitable basis for performance evaluation.


Limitations
(i) As a result of product differentiation, ther may be no comparable product or a single market price.
(ii) Market price may vary because of over-supply or under-supply, promotions, or ‘product dumping’ by foreign competitors.


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Full-cost based Transfer Price

Market conditions which are appropriate for adoption
• In an imperfect market, it may be unwise to always set transfer price exactly at the variable costs of production, as such prices do not provide for the replacement of fixed assets.
• The Supply Division (SD) will want to base the transfer price on total absorption cost to ensure that it will provide a contribution to cover the fixed overheads.
• Full-cost based transfer price is widely used because managers require an estimate of long-run marginal cost for decision-making. However, traditional absorption costing systems tend to provide poor estimates of long-run marginal cost for decision-making. ABC will provide better estimates of long run MC.


Limitations
(i) It can lead buying division (BD) to make “sub-optimal” decisions because BD regards the transfer price (which includes the fixed costs) as a wholly variable cost.

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Negotiated Transfer Price

Market conditions which are appropriate for adoption
• In an imperfect market (different selling costs for internal and external sales, differential market prices), transfer prices set at the prevailing or planned market price are not optimal i.e. will not induce SD and BD to adopt optimal output level. Central/corporate management intervention is necessary in order to ensure that optimal output levels are set but this process may undermine divisional autonomy.
• In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers had been provided with all the information and were educated to use information correctly, it is likely that a negotiated solution would have emerged which would have been acceptable to both the divisions and the group.
• When there is unused capacity, the transfer price range for negotiations generally lied between the minimum price at which SD is willing to sell (its marginal cost) and the maximum price BD is willing to pay (the external supplier price net off any external purchase related costs).


Limitations
(i) Can lead to sub-optimal decisions
(ii) Time-consuming
(iii) Strongly influenced by the bargaining skills and power of the divisional managers
(iv) Inappropriate in certain circumstances (e.g. no market for the intermediate product or an imperfect market exists as the SD will have a bargaining disadvantage)




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