A General Guideline for Transfer-Pricing Situations

Learning Objective 8 Apply a general guideline for determining a minimum transfer price

• incremental cost plus opportunity cost of supplying division

Exhibit 23-3 summarizes the properties of market-based, cost-based, and negotiated transfer-pricing methods using the criteria we have described in this chapter. As the exhibit indicates, it is difficult for a transfer-pricing method to meet all the criteria. The transfer price a company will eventually choose depends on the economic circumstances and the decision being made. Surveys by Ernst & Young as well as those sponsored by the Institute of Management Accountants indicate that full-cost-based transfer pricing is generally the most frequently used method around the world, followed by market-based and negotiated transfer pricing methods.^*

Our discussion so far highlights that, barring settings in which a perfectly competitive market exists for the intermediate product, there is typically a range of possible transfer prices that would promote goal congruence. The following formula provides a general guideline for determining the minimum price in that range:

The incremental cost in the formula is the additional cost of producing and transferring the product or service. The opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally. For example, if the selling subunit is operating at capacity, the opportunity cost of transferring a unit internally rather than selling it externally is equal to the market price minus the variable cost. That’s because by transferring a unit internally, the subunit forgoes the contribution margin it could have obtained by selling the unit in the external market. We distinguish the incremental cost from the opportunity cost because financial accounting systems record incremental cost but do not record opportunity cost. The guideline measures a minimum transfer price because it represents the selling unit’s cost of transferring the product. We illustrate the general guideline in some specific situations using data from Horizon Petroleum.

1. A PERFECTLY COMPETITIVE MARKET FOR THE INTERMEDIATE PRODUCT EXISTS, AND THE SELLING DIVISION HAS NO UNUSED CAPACITY. If the market for crude oil in Houston is perfectly competitive, the transportation division can sell all the crude oil it transports to the external market at $85 per barrel, and it will have no unused capacity. The transportation division’s incremental cost (as shown in Exhibit 23-1) is $73 per barrel (the purchase cost of $72 per barrel plus the variable transportation cost of $1 per barrel) for oil purchased under the long-term contract or $80 per barrel (the purchase cost of $79 plus the variable transportation cost of $1) for oil purchased at current market prices from Gulfmex. The transportation division’s opportunity cost per barrel of transferring the oil internally is the contribution margin per barrel forgone by not selling the crude oil in the external market: $12 for oil purchased under the long-term contract (the market price, $85, minus the variable cost, $73) and $5 for oil purchased from Gulfmex (the market price, $85, minus the variable cost, $80). In either case,

2. AN INTERMEDIATE MARKET EXISTS THAT IS NOT PERFECTLY COMPETITIVE, AND THE SELLING DIVISION HAS UNUSED CAPACITY. In markets that are not perfectly competitive, companies can increase their capacity utilization only by decreasing their prices. Unused capacity exists because decreasing prices is often not worthwhile—it decreases operating income.

1. If the transportation division at Horizon Petroleum has unused capacity, its opportunity cost of transferring the oil internally is zero because the division does not forgo any external sales or contribution margin from internal transfers. In this case,

1. In general, when markets are not perfectly competitive, the impact of prices on demand (and operating income) complicates the measurement of opportunity costs. The transfer price depends on constantly changing levels of supply and demand. There is not just one transfer price. Rather, the transfer prices for various quantities supplied and demanded depend on the incremental costs and opportunity costs of the units transferred.

3. NO MARKET EXISTS FOR THE INTERMEDIATE PRODUCT. This situation would occur if the crude oil transported by the transportation division could be used only by the Houston refinery (due to, say, its high tar content) and would not be wanted by external parties. Here the opportunity cost of supplying crude oil internally is zero because it can’t be sold externally, so no contribution margin is forgone. For the transportation division, the minimum transfer price under the general guideline is the incremental cost per barrel (either $73 or $80). As in the previous case, any transfer price between the incremental cost and $85 will achieve goal congruence.