Learning Objective 7 Describe the range of feasible transfer prices when there is unused capacity and alternative methods for arriving at the eventual hybrid price
Consider again Horizon Petroleum. As we saw earlier, the transportation division has unused capacity it can use to transport oil from Matamoros to Houston at an incremental cost of $80 per barrel. Horizon Petroleum, as a whole, maximizes its operating income if the refining division purchases crude oil from the transportation division rather than from the Houston market (the incremental cost per barrel is $80 versus the price per barrel of $85). Both divisions would be interested in transacting with each other (and the firm achieves goal congruence) if the transfer price is between $80 and $85.
For any internal transaction, there is generally a minimum transfer price the selling division will not go below, based on its cost structure. In the Horizon Petroleum example, the minimum price acceptable to the transportation division is $80. There is also a maximum price the buying division will not wish to exceed, which is determined by the lower of two quantities—the eventual contribution the division generates from an internal transaction and the price of purchasing a comparable intermediate product from an outside party. For the refining division, each barrel of gasoline sold to external parties generates $182 in contribution (the $190 price less the $8 variable cost of refining). Because it takes two barrels of crude oil to generate a barrel of gasoline, this is equivalent to a contribution of $91 per barrel of crude oil. For any price higher than $91, the refining division would lose money for each barrel of crude oil it buys from the transportation division. On the other hand, the refining division can purchase crude oil on the open market for $85 rather than having it transported internally. The maximum feasible transfer price is thus the lower of $91 and $85, or $85 in this instance. We saw previously that a transfer price between the minimum price ($80) and the maximum ($85) would promote goal congruence. We now describe three different ways in which firms attempt to determine the specific transfer price within these bounds.
One approach that Horizon Petroleum could pursue is to choose a transfer price that splits, on some fair basis, the $5 difference between the $85-per-barrel market-based maximum price the refining division is willing to pay and the $80-per-barrel variable cost-based minimum price the transportation division wants to receive. An easy solution is to split the difference equally, resulting in a transfer price of $82.50. However, this solution ignores the relative costs incurred by the two divisions and might lead to disparate profit margins on the work contributed by each division to the final product. As an alternative approach, Horizon Petroleum could allocate the $5 difference on the basis of the variable costs of the two divisions. Using the data in Exhibit 23-1, variable costs are as follows:
The table depicts variable costs for Horizon Petroleum. The details of the table are as follows:
1. Transportation division’s variable costs to transport 100 barrels of crude oil, 1 dollar times 100: 100 dollars
2. Refining division’s variable costs to refine 100 barrels of crude oil and produce 50 barrels
of gasoline, 8 dollars times 50: 400 dollars
3. Total variable costs: 500 dollars
Of the $5 difference, the transportation division gets to keep and the refining division gets to keep That is, the transfer price is $81 per barrel of crude oil ( that the transportation division gets to keep). In effect, this approach results in a budgeted variable-cost-plus transfer price.
To decide on the $1 and $4 allocations of the $5 incremental benefit to the company’s total operating income per barrel, the divisions must share information about their variable costs. In effect, each division does not operate (at least for this transaction) in a totally decentralized manner. Furthermore, each division has an incentive to overstate its variable costs to receive a more-favorable transfer price. In the preceding example, suppose the transportation division claims it costs $2 per barrel to ship crude oil from Gulfmex to Houston. This increased cost raises the variable cost-based minimum price to per barrel; the maximum price remains $85. Of the $4 difference between the minimum and maximum, the transportation division now gets to keep resulting in a higher transfer price of $82.33. The refining division similarly benefits from asserting that its variable cost to refine 100 barrels of crude oil is greater than $400. As a consequence, proration methods either require a high degree of trust and exchange of information among divisions or include provisions for objective audits of cost information in order to be successful.