Transfer Pricing

Learning Objective 3 Explain transfer prices and the four criteria managers use to evaluate them

• price one subunit charges another for product
• goal congruence, management effort, subunit performance evaluation, and subunit autonomy

In a decentralized organization, much of the decision-making power resides in its individual subunits. Often, the subunits interact by supplying goods or services to one another. In these cases, top management uses transfer prices to coordinate the actions of the subunits and to evaluate the performance of their managers.

A transfer price is the price one subunit (department or division) charges for a product or service supplied to another subunit within the same organization. If, for example, a car manufacturer like BMW or Ford has separate divisions for manufacturing engines and assembling cars, the transfer price is the price the engine division charges when it transfers engines to the car assembly division. The transfer price creates revenues for the selling subunit (the engine division in our example) and costs for the buying subunit (the assembly division in our example), affecting each subunit’s operating income. These operating incomes can be used to evaluate the subunits’ performances and to motivate their managers. The product or service transferred between subunits of an organization is called an intermediate product. The receiving unit (the assembly division in the engine example) may work on the product further or the product may be transferred from production to marketing and sold directly on the external market.

In one sense, transfer pricing is a curious phenomenon. Activities within an organization are clearly nonmarket in nature; products and services are not bought and sold as they are in open-market transactions. Yet establishing prices for transfers among subunits of a company has a distinctly market flavor. The rationale for transfer prices is that they allow subunit managers (such as the manager of the engine division) to focus only on the performance of their subunits when making decisions without having to evaluate how their decisions affect ­company-wide performance. In this sense, transfer prices ease the subunit managers’ ­information-processing and decision-making tasks. In a well-designed transfer-pricing system, ­managers focus on maximizing the performance of their subunits and in doing so optimize the performance of the company as a whole.

Criteria for Evaluating Transfer Prices

To help a company achieve its goals, transfer prices should meet four key criteria:

1. Promote goal congruence, so that division managers acting in their own interest will take actions that are aligned with the objectives of top management.
2. Induce managers to exert a high level of effort. Subunits selling a product or service should be motivated to hold down their costs; subunits buying the product or service should be motivated to acquire and use inputs efficiently.
3. Help top managers evaluate the performance of individual subunits.
4. Preserve autonomy of subunits if top managers favor a high degree of decentralization. A subunit manager seeking to maximize the operating income of the subunit should have the freedom to transact with other subunits of the company (on the basis of transfer prices) or to transact with external parties.