Negotiated pricing is the most common hybrid method. Under this approach, top managers do not administer a specific split of the eventual profits across the transacting divisions. Rather, the eventual transfer price results from a bargaining process between the selling and buying subunits. In Horizon Petroleum’s case, for example, the transportation division and the refining division would be free to negotiate a price that is acceptable to both.
Recall that the minimum and maximum feasible transfer prices are $80 and $85, respectively, per barrel of crude oil. Where in this interval will the transfer price per barrel be set? Under a negotiated transfer price, the answer depends on several things: the bargaining strengths of the two divisions; information the transportation division has about the price minus the incremental marketing costs of supplying crude oil to outside refineries; and the information the refining division has about its other available sources of crude oil. The negotiations become particularly sensitive when each division’s performance is evaluated on the basis of its operating income. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or the market price. But the cost and price information is often the starting point in the negotiation process.
Consider the following situation: Suppose the refining division receives an order to supply specially processed gasoline. The incremental cost to purchase and supply crude oil is still $80 per barrel. However, suppose the refining division will profit from this order only if the transportation division can supply crude oil at a price not exceeding $82 per barrel.* In this case, the transfer price that would benefit both divisions must be greater than $80 but less than $82. Negotiations would allow the two divisions to achieve an acceptable transfer price. By contrast, a rule-based transfer price, such as a market-based price of $85 or a 105% of full-cost-based price of $87.15, would result in Horizon passing up a profitable opportunity.
A negotiated transfer price strongly preserves the autonomy of divisions, and the division managers are motivated to put forth effort to increase the operating income of their respective divisions. Surveys have found that approximately 15–20% of firms set transfer prices based on negotiation. Firms that do not use negotiated prices believe the time and energy spent by managers haggling over transfer prices make the method too costly.