Calculating Transfer Prices

Learning Objective 4 Calculate transfer prices using three methods

• (1) market based, (2) cost based, or (3) hybrid, each of which yields different operating incomes for the subunits

There are three broad categories of methods top managers can use to determine transfer prices:

1. MARKET-BASED TRANSFER PRICES. Top managers may choose to use the price of a similar product or service publicly listed on, say, a trade association’s website. Or they may select the external price a subunit charges outside customers.
2. COST-BASED TRANSFER PRICES. Top managers may choose a transfer price based on the cost of producing the product being transferred. Examples include the variable production cost, variable and fixed production costs, and full cost of the product. The full cost of the product includes all production costs plus costs from other business functions (research and development, design, marketing, distribution, and customer service). The cost used in cost-based transfer prices can be actual cost or budgeted cost. Sometimes, the cost-based transfer price includes a markup or profit margin that represents a return on subunit investment.
3. HYBRID TRANSFER PRICES. Hybrid transfer prices take into account both cost and market information. Top managers may set the prices by specifying a transfer price that is an average of the cost of producing and transporting the product internally and the market price for comparable products. At other times, a hybrid transfer price may allow for the revenue recognized by the selling unit to differ from the cost recognized by the buying unit. The most common form of hybrid prices arises via negotiation—the subunit managers are asked to negotiate the transfer price between them and to decide whether to buy and sell internally or deal with external parties. Negotiated transfer prices are often employed when market prices are volatile. Thus, managers need current information about the costs and prices of products to participate in the bargaining process.

Under what circumstances should each of these options be used? To answer this question, we next demonstrate how each of the three transfer-pricing methods works and highlight the differences among them. We examine transfer pricing at Horizon Petroleum against the four criteria of promoting goal congruence, motivating management effort, evaluating subunit performance, and preserving subunit autonomy.

An Illustration of Transfer Pricing

Horizon Petroleum has two divisions, each operating as a profit center. The transportation division purchases crude oil in Matamoros, Mexico, and transports it from Matamoros to Houston, Texas. The refining division processes crude oil into gasoline. For simplicity, we assume gasoline is the only salable product the Houston refinery makes and that it takes two barrels of crude oil to yield one barrel of gasoline.

The variable costs of each division are associated with a single cost driver: barrels of crude oil transported by the transportation division and barrels of gasoline produced by the refining division. The fixed cost per unit is based on the budgeted annual fixed costs and practical capacity of crude oil that can be transported by the transportation division, as well as the budgeted annual fixed costs and practical capacity of gasoline that can be produced by the refining division. Horizon Petroleum reports all costs and revenues of its non-U.S. operations in U.S. dollars using the prevailing exchange rate.

• The transportation division has obtained rights to certain oil fields in the Matamoros area. It has a long-term contract to purchase crude oil extracted from these fields at $72 per barrel. The division transports the oil to Houston and then “sells” it to the refining division. The pipeline from Matamoros to Houston can transport 40,000 barrels of crude oil per day.
• The refining division has been operating at capacity (30,000 barrels of crude oil a day), using oil supplied by Horizon’s transportation division (an average of 10,000 barrels per day) and oil bought from another producer and delivered to the Houston refinery (an average of 20,000 barrels per day at $85 per barrel).
• The refining division sells the gasoline it produces to outside parties at $190 per barrel.

Exhibit 23-1 summarizes Horizon Petroleum’s variable and fixed costs per barrel of crude oil in the transportation division and variable and fixed costs per barrel of gasoline in the refining division, the external market price of buying crude oil, and the external market price of selling gasoline. What’s missing in the exhibit is the actual transfer price paid by the refining division to the transportation division. This transfer price will vary depending on the ­transfer-pricing method used. The transfer prices paid by the refining division to the transportation division under each of the three methods are as follows:

1. A market-based transfer price of $85 per barrel of crude oil based on the competitive market price in Houston.
2. A cost-based transfer price at, say, 105% of full cost, where the full cost is the cost of the crude oil purchased in Matamoros plus the transportation division’s own variable and fixed costs (from Exhibit 23-1): $1.05\times (\mathrm{\$}72+\mathrm{\$}1+\mathrm{\$}3)=\mathrm{\$}79.80\mathrm{.}$
3. A hybrid transfer price of, say, $82 per barrel of crude oil, which is between the market-based and cost-based transfer prices. We describe later in this section the various ways in which hybrid prices can be determined.

Exhibit 23-2 presents division operating incomes for 100 barrels of crude oil purchased under each transfer-pricing method. Transfer prices create income for the selling division and corresponding costs for the buying division that cancel out when divisional results are consolidated for the company as a whole. The exhibit assumes all three transfer-pricing methods yield transfer prices that are in a range that does not cause division managers to change the business relationships shown in Exhibit 23-1. That is, Horizon Petroleum’s total operating income from purchasing, transporting, and refining the 100 barrels of crude oil and selling the 50 barrels of gasoline is the same ($1,200) regardless of the internal transfer prices used.

Under all three methods, summing the two division operating incomes equals Horizon Petroleum’s total operating income of $1,200. By keeping the total operating income the same, we focus attention on the effects different transfer-pricing methods have on the operating income of each division. Subsequent sections of this chapter show that the choice of transfer-pricing method can cause managers to take actions that lead to different total operating incomes for the company as a whole.

Consider the two methods in columns B and E of Exhibit 23-2. The operating income of the transportation division is $520 more ($\mathrm{\$}900-\mathrm{\$}380$) if transfer prices are based on market prices rather than on 105% of the full cost. Correspondingly, the operating income of the refining division is $520 lower ($\$820 - \$300$) if transfer prices are based on market prices rather than 105% of the full cost. If the transportation division’s sole criterion were to maximize its own operating income, it would favor transfer prices at market prices. In contrast, the refining division would prefer transfer prices at 105% of full cost to maximize its own operating income. The hybrid transfer price of $82 is between the 105% of full cost and market-based transfer prices. It splits the $1,200 of operating income equally between the divisions. This price could arise as a result of negotiations between the transportation and refining division managers.

It’s not surprising that subunit managers, especially those whose compensation or promotion directly depends on subunit operating income, take considerable interest in setting transfer prices. To reduce the excessive focus of subunit managers on their own divisions, many companies compensate subunit managers on the basis of both the operating income earned by their respective divisions and the company as a whole.

We next examine market-based, cost-based, and hybrid transfer prices in more detail. We show how the choice of transfer-pricing method can determine the size of the total company-wide operating-income pie.