Learning Objective 6 Understand how to avoid making suboptimal decisions when transfer prices are based on full cost plus a markup
Cost-based transfer prices are helpful when market prices are unavailable, inappropriate, or too costly to obtain. This can occur, for example, when markets are not perfectly competitive, when the product is specialized, or when the internal product is different from the products available externally in terms of its quality and the customer service provided for it.
In practice, many companies use transfer prices based on a product’s full cost. To approximate market prices, cost-based transfer prices are sometimes set at the full cost plus a margin. These transfer prices, however, can lead to suboptimal decisions. Suppose Horizon Petroleum makes internal transfers at 105% of the full cost. Recall that the refining division purchases, on average, 20,000 barrels of crude oil per day from a local Houston supplier, who delivers the crude oil to the refinery at a price of $85 per barrel. To reduce its crude oil costs, the refining division has located an independent producer in Matamoros—Gulfmex Corporation—that is willing to sell 20,000 barrels of crude oil per day at $79 per barrel, delivered to Horizon’s pipeline in Matamoros. Given Horizon’s organizational structure, the transportation division would purchase the 20,000 barrels of crude oil in Matamoros from Gulfmex, transport it to Houston, and then sell it to the refining division. The pipeline has unused capacity and can ship the 20,000 barrels per day at its variable cost of $1 per barrel without affecting the shipment of the 10,000 barrels of crude oil per day acquired under its existing long-term contract arrangement. Will Horizon Petroleum incur lower costs by purchasing crude oil from Gulfmex in Matamoros or by purchasing crude oil from the Houston supplier? Will the refining division show lower crude oil purchasing costs by acquiring oil from Gulfmex or by acquiring oil from its current Houston supplier?
The following analysis shows that Horizon Petroleum’s operating income would be maximized by purchasing oil from Gulfmex. The analysis compares the incremental costs in both divisions under the two alternatives. The analysis assumes the fixed costs of the transportation division will be the same regardless of the alternative chosen. That is, the transportation division cannot save any of its fixed costs if it does not transport Gulfmex’s 20,000 barrels of crude oil per day.
There is a reduction in total costs to Horizon Petroleum of $100,000 by acquiring oil from Gulfmex.
Suppose the transfer price paid by the refining division to the transportation division is 105% of the full cost of the transportation division. The refining division will see its reported division costs increase if the crude oil is purchased from Gulfmex:
As a profit center, the refining division can maximize its short-run division operating income by purchasing from the Houston supplier.
The refining division looks at each barrel that it obtains from the transportation division as a variable cost of $87.15 per barrel; if 10 barrels are transferred, it costs the refining division $871.50; if 100 barrels are transferred, it costs $8,715. In fact, the variable cost per barrel is $80 ($79 to purchase the oil from Gulfmex plus $1 to transport it to Houston). The remaining per barrel is the transportation division’s fixed cost and markup. The full cost plus a markup transfer-pricing method causes the refining division to regard the fixed cost (and the 5% markup) of the transportation division as a variable cost and leads to goal incongruence.
Should Horizon’s top managers interfere and force the refining division to buy from the transportation division? Doing so would undercut the philosophy of decentralization, so Horizon’s top managers would probably view the decision by the refining division to purchase crude oil from external suppliers as an inevitable cost of decentralization and not interfere. Of course, some interference may occasionally be necessary to prevent costly blunders. But recurring interference would simply transform Horizon from a decentralized company into a centralized company.
What transfer price will promote goal congruence for both the transportation and refining divisions? The minimum transfer price is $80 per barrel. A transfer price below $80 does not provide the transportation division with an incentive to purchase crude oil from Gulfmex in Matamoros because it is below the transportation division’s incremental costs. The maximum transfer price is $85 per barrel. A transfer price above $85 will cause the refining division to purchase crude oil from the external market in Houston rather than from the transportation division. A transfer price between the minimum and maximum transfer prices of $80 and $85 will promote goal congruence: Each division will increase its own reported operating income while increasing Horizon Petroleum’s operating income if the refining division purchases crude oil from Gulfmex in Matamoros.
When using transfer prices based on costs rather than market prices, Horizon’s top managers cannot easily determine the profitability of the investment made in the transportation division and hence whether Horizon should keep or sell the pipeline. Furthermore, if transfer prices are based on the actual costs of the transportation division, it would provide the division with no incentive to control costs. That’s because all cost inefficiencies of the transportation division would get passed along as part of the actual full-cost transfer price. In fact, every additional dollar of cost arising from wastefulness in the transportation division would generate an additional $0.05 in profit for the division under the “105% of full cost” rule!
Surveys by accounting firms and researchers indicate that, despite its limitations, managers generally prefer to use full-cost-based transfer prices because (1) they represent relevant costs for long-run decisions, (2) they facilitate external pricing based on variable and fixed costs, and (3) they are the least costly to administer. However, full-cost transfer pricing does raise many issues. How are each subunit’s indirect costs allocated to products? Have the correct activities, cost pools, and cost-allocation bases been identified? Should the chosen fixed-cost rates be actual or budgeted? The issues here are similar to the issues related to allocating fixed costs, discussed in Chapter 15. Many companies determine the transfer price based on budgeted rates and practical capacity because it overcomes the problem of inefficiencies in actual costs and costs of unused capacity getting passed along to the buying division.