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A common example of decentralized decision making occurs when business units (divisions) within the organization buy goods and services from one another and when each is treated as a profit center (i.e., when each unit manager is evaluated on reported unit profit). When such exchange occurs, the accounting systems in the two divisions record the transaction as if it were an ordinary sale (purchase) to (from) an external customer (supplier). The price at which the transaction is recorded is the transfer price. The profit on the sale that accrues to the selling division is simply the transfer price less the cost of goods sold. The profit that will accrue to the buying division when the item is sold to an external customer is the revenue from the external sale less the transfer price less any additional cost incurred by the buying division to complete the product.
A transfer price is the value or amount recorded in a firm's accounting records when one business unit sells (transfers) a good or service to another business unit. The accounting records in the two units (responsibility centers) treat this transaction in exactly the same way as a sale to an outside customer. Because the exchange takes place within the organization, however, the firm has considerable discretion in setting this transfer price. Just as with prices determined on an open market, transfer prices are widely used for decision making, product costing, and performance evaluation; hence, it is important to consider alternative transfer pricing methods and their advantages and disadvantages.
What makes the transfer price important is the it affects the divisions manager's decisions about whether to engage in the transaction. Because the managers of both the selling division and buying division are evaluated on division profit, not company profit, they consider the effect of all sales both internal and external, on their own performance measure.
The optimal transfer price is the price that leads both division managers, each acting in his or her own self-interest, to make decisions that are in the firm's interest. In other words, if a transaction would increase firm profits, it must be profitable for both divisions, given the transfer price to make the transaction, or the selected transfer price cannot be the optimal price.
DETERMINING THE OPTIMAL TRANSFER PRICE
Keeping separate accounting records and using transfer prices to record exchanges among divisions allow firms to delegate decisions to local managers ( and benefit from better decisions) while holding these same managers responsible for divisional performance. The transfer price is a device to motivate managers to act in the best interest of the company.
The following example of company White Paper will illustrate the analysis used to determine the optimal transfer price. This company consists of two divisions, Wood and Paper. Wood division "makes" wood, which can be sold as wood or used as an input in manufacturing paper. In addition to customers not affiliated with White Paper, it "sells" the wood to paper division, which uses it to manufacture paper. Paper division then sells its products (paper) to customers that are external to White Paper. Both Wood and Paper divisions are profit centers under the company's new organization, and the division managers are evaluated and compensated based on divisional profits.
The following tables show 1) some basic data for White Paper and 2) an illustration of the resource flow and certain cost data for the company. Note that in illustration #2 that Wood division might sell its products in the wood market, which we refer to as the intermediate market. Paper division might purchase wood from the intermediate market, but it sells paper in the final market.
WHETHER A TRANSFER PRICE IS OPTIMAL
Before we describe the analysis to follow in computing the optimal
transfer price, we provide a simple test to determine whether the
calculated transfer price is optimal. This test is an application of
the differential profitability analysis, and is applied three times:
once for the firm and once for each of the two divisions.
1.- Given the market prices and the costs in the firm, does the
transfer increase firm profit?
1: A PERFECT INTERMEDIATE MARKET
Economists call a market perfect if buyers can buy and sellers can sell
any quantity without affecting the price. This means, of course, that
the product being sold is not differentiated by quality, service, or
To test whether the market price is the best transfer price, consider various prices in the intermediate (wood) and final (paper) markets. If the market price is the best transfer price, then, regardless of these external market prices, the two division managers, acting independently, will make the transfer that the corporate staff would set if it had all the information that the division managers have. For example, suppose the final market price for paper is $120 and the intermediate market price for wood is $50. Then, using the intermediate market price as the transfer price, the transfer price is set at $50. At these market prices, does White Paper (as a firm) want to sell paper? The company receives $120 for every unit sold. The total variable cost is $50 (= $20 Wood cost + $30 Paper cost). The firm wants to make the sale. Wood Division is indiferent between buying wood from Wood division or the intermediate market. Paper division is indiferent between buying wood from Wood Division or the intermediate market. Therefore, the sale will be made and the source of wood to Paper Division does not affect firm profits.
CASE 1A: PERFECT
INTERMEDIATE MARKET - QUALITY DIFERENCES
Suppose that there are two grades of wood, grade A (better) and grade
(B). Suppose that either grade can be used to make paper and the there
are perfect markets for different grades. The intermediate market price
for grade A wood is $60 and for grade B is $50 per unit. Wood division
supplies grade A. What is the optimal transfer price?
Clearly, a change in the transfer price does not change
the total company operating profit but does impact division
performance. Wood Division would prefer the higher transfer because its
operating profit increases form $1,000,000 to $2,000,000, especially if
management is evaluated on divisional operating profit. Paper Division
would prefer the lower transfer price. As we next show, however, the
company can increase its profits by allowing the managers to decide
where to trade.
The optimal transfer price in this case, even thought no
transfers will take place, is the intermediate market price for grade A
wood. This is the value of the wood that Wood Division produces. By
using the intermediate market price for grade A wood as the transfer
price, the firm ensures that the managers understand the opportunity
cost of using the wood from Wood Division in paper manufacturing. The
manager loses the opportunity to sell it in the intermediate market,
where the current price is $60. Thus, the paper division manager will
face the same decision the firm would if it were making the decision:
Use grade A wood at a cost of $60 or grade B wood at a cost of $50. The
optimal transfer price is sending the correct "signal" to the
2: NO INTERMEDIATE MARKET
Suppose that no intermediate market for wood exists or that, for
whatever reason, the company has decided that it will not allow
the divisions to buy or sell wood. In this case, the only outlet for
Wood Division is Paper Division and the only source of supply for Paper
Division is Wood Division. Some potential transfer prices can be
disregarded immediately as being suboptimal. At any transfer price
below $20 -- the variable cost in Wood Division-- no transfers will
take place because wood will loose money on each unit sold. Any
transfer price above the final (paper) market price less the $30
variable processing cost of Paper Division will also not be optimal
because Paper will not buy any wood.
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