Transferring products or services at market prices generally leads to optimal decisions when three conditions are satisfied: (1) The market for the intermediate product is perfectly competitive, (2) the interdependencies of subunits are minimal, and (3) there are no additional costs or benefits to the company as a whole from buying or selling on the external market instead of transacting internally.
A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyers or sellers can affect those prices by their own actions. By using market-based transfer prices in perfectly competitive markets, a company can (1) promote goal congruence, (2) motivate management effort, (3) evaluate the performance of subunits, and (4) preserve their autonomy.
Consider Horizon Petroleum again. Assume there is a perfectly competitive market for crude oil in the Houston area. As a result, the transportation division can sell and the refining division can buy as much crude oil as each wants at $85 per barrel. Horizon would prefer its managers to buy or sell crude oil internally. Think about the decisions that Horizon’s division managers would make if each had the autonomy to sell or buy crude oil externally. If the transfer price between Horizon’s transportation and refining divisions is set below $85, the manager of the transportation division will be motivated to sell all crude oil to external buyers in the Houston area at $85 per barrel. If the transfer price is set above $85, the manager of the refining division will be motivated to purchase all crude oil from external suppliers. Only an $85 transfer price will motivate the transportation division and the refining division to buy and sell internally. That’s because neither division profits by buying or selling on the external market.
Suppose Horizon evaluates its division managers on the basis of their individual division’s operating income. The transportation division will sell, either internally or externally, as much crude oil as it can profitably transport, and the refining division will buy, either internally or externally, as much crude oil as it can profitably refine. An $85-per-barrel transfer price results in goal congruence—the actions that maximize each division’s operating income are also the actions that maximize the operating income of Horizon Petroleum as a whole. Furthermore, because the transfer price is not based on costs, it motivates each division manager to maximize his or her own division’s operating income. Market prices also serve to evaluate the economic viability and profitability of each division individually. For example, Koch Industries, the second-largest private company in the United States, uses market-based pricing for all internal transfers. As its CFO, Steve Feilmeier, noted, “We believe that the alternative for any given asset should always be considered in order to best optimize the profitability of the asset. If you simply transfer price between two different divisions at cost, then you may be subsidizing your whole operation and not know it.” Returning to our Horizon example, suppose that under market-based transfer prices, the refining division consistently shows small or negative profits. Then Horizon may consider shutting down the refining division and simply transport and sell the oil to other refineries in the Houston area.