The Fuqua School of Business International Strategy: WBA 434Duke University Professors Heath, Huddart, & SlottaTransfer Pricing1. OverviewAn essential feature of decentralized firms is responsibility centers (e.g.,cost-, profit-, revenue-, or investment-centers). The performance of theseresponsibility centers is evaluated on the basis of various accounting numbers,such as standard cost, divisional profit, or return on investment (as well as onthe basis of other non-accounting measures, like market share). One functionof the management accounting system therefore is to attach a dollar figureto transactions between different responsibility centers. The transfer priceis the price that one division of a company charges another division of thesame company for a product transferred between the two divisions.The basic purpose of transfer pricing is to induce optimal decisionmaking in a decentralized organization (i.e., in most cases, to maximize theprofit of the organization as a whole).Profit Center : Any sub-unit of an organization that is assigned both rev-enues and expenses. In a profit center, a manager is treatedas an entrepreneur. Typically, a profit center manager isgiven decision-making power and is held responsible for theprofits generated by her center.2. Advantages and Disadvantages of Decentralization2.1 Advantages• Decisions are better and more timely because of the manager’s proximityto local conditions.• Top managers are not distracted by routine, local decision problems.• Managers’ motivation increases because they have more control overresults.Based on a note by Nahum Melumad.c!Heath, Huddart & Slotta, 2009. All rights reserved. www.personal.psu.edu/sjh11WBA 434: International Strategy Transfer Pricing• Increased decision making provides better training for managers forhigher level positions in the future.2.2 Disadvantages• Lack of goal congruence among managers in different parts of theorganization.• Insufficient information available to top management; increased costs ofobtaining detailed information.• Lack of coordination among managers in different parts of the organi-zation.3. Purposes of Transfer PricingThere are two main reasons for instituting a transfer pricing scheme:• Generate separate profit figures for each division and thereby evaluatethe performance of each division separately.• Help coordinate production, sales and pricing decisions of the differentdivisions (via an appropriate choice of transfer prices). Transfer pricesmake managers aware of the value that goods and services have for othersegments of the firm.• Transfer pricing allows the company to generate profit (or cost) figuresfor each division separately.• The transfer price will affect not only the reported profit of each center,but will also affect the allocation of an organization’s resources.4. Mechanics of Transfer Pricing• No money need change hands between the two divisions. The transferprice might only be used for internal record keeping.• (Transfer Price × quantity of goods exchanged) is an expense for thepurchasing center and a revenue for the selling center.Page 2Transfer Pricing International Strategy: WBA 4345. Accounting for Transfer PricingIf intra-company transactions are accounted for at prices in excess ofcost, appropriate elimination entries should be made for external reportingpurposes. Examples of items to be eliminated for consolidated financialstatements include:• Intracompany receivables and payables.• Intracompany sales and costs of goods sold.• Intracompany profits in inventories.6. Alternative Methods of Transfer PricingA transfer pricing policy defines rules for calculating the transfer price.In addition, a transfer price policy has to specify sourcing rules (i.e.,either mandate internal transactions or allow divisions discretion in choosingwhether to buy/sell externally). The most common transfer pricing methodsare described below.6.1 Market-based Transfer PricingWhen the outside market for the good is well-defined, competitive, andstable, firms often use the market price as an upper bound for the transferprice.Concerns with market-based Transfer PricingWhen the outside market is neither competitive nor stable, internaldecision making may be distorted by reliance on market-based transfer pricesif competitors are selling at distress prices or are engaged in any of a varietyof “special” pricing strategies (e.g., price discrimination, product tie-ins, orentry deterrence). Also, reliance on market prices makes it difficult to protect“infant” segments.6.2 Negotiated Transfer PricingHere, the firm does not specify rules for the determination of transferprices. Divisional managers are encouraged to negotiate a mutually agreeabletransfer price. Negotiated transfer pricing is typically combined with freesourcing. In some companies, though, headquarters reserves the right tomediate the negotiation process and impose an “arbitrated” solution.Page 3WBA 434: International Strategy Transfer Pricing6.3 Cost-based Transfer PricingIn the absence of an established market price many companies base thetransfer price on the production cost of the supplying division. The mostcommon methods are:• Full Cost• Cost-plus• Variable Cost plus Lump Sum charge• Variable Cost plus Opportunity cost• Dual Transfer PricesEach of these methods is outlined below.6.3.1 Full CostA popular transfer price because of its clarity and convenience andbecause it is often viewed as a satisfactory approximation of outside marketprices.(i) Full actual costs can include inefficiencies; thus its usage for transferpricing often fails to provide an incentive to control such inefficien-cies.(ii) Use of full standard costs may minimize the inefficiencies mentionedabove.6.3.2 Cost-plusWhen transfers are made at full cost, the buying division takes all thegains from trade while the supplying division receives none. To overcomethis problem the supplying division is frequently allowed to add a mark-upin order to make a “reasonable” profit. The transfer price may then beviewed as an approximate market price.6.3.3 Variable Cost plus a Lump Sum ChargeIn order to motivate the buying division to make appropriate purchasingdecisions, the transfer price could be set equal to (standard) variable costplus a lump-sum periodical charge covering the supplying division’s relatedfixed costs.Page 4Transfer Pricing International Strategy: WBA 4346.3.4 Variable Cost plus