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.
         

	Wood Division	Paper Division
Average units produced	100,000
Average units sold		100,000
Variable manufacturing cost per unit	$20
Variable finishing cost per unit		$30
Fixed divisional costs (unavoidable)	$2,000,000	$4,000,000

        

          DETERMINING 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?
         2.- Given the transfer price, the intermediate market prices, and the divisional costs, does the transfer price increase the selling
               division profit?
         3.- Given the transfer price, the final market prices, and the divisional costs, does the transfer price increase the buying divisional
               profit?
 
       If the answer to the first question is yes, the answers to questions 2 and 3 must also be yes or the transfer price is not optimal. It is not optimal because the transfer increases the firm's profits, but one (or both) of the division managers will not make the transfer because it lowers the division's profits. If the answer to the first question is no, the answer the either question 2 or 3 (or both) must be no or the transfer price is not optimal.
       In determining the optimal transfer price, the important issue is the nature of the intermediate market, the market for the good being transferred. Our analysis considers two cases: 1) a perfect intermediate market and 2) no intermediate market. (If there is an intermediate market, but company policy forbids divisions from buying or selling from the outside, the analysis is the same as case 2, not intermediate market).

           CASE 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 other characteristics.

             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?
         We know from the preceding analysis that the optimal transfer price is the intermediate market price, but which market do we use? If we allow the division managers to choose where tu buy and sell, we know that Wood Division will sell its output on the intermediate (grade A) market for $60 and Paper Division will buy wood on the intermediate (grade B) market for $50. In this case, the transfer price is irrelevant because no transfers would be made. These are also the optimal decisions from the firm's perspective. The following differential profitability analysis confirms this:

Alternative 1: Require Internal Transfer at Transfer Price of $50 per Unit
	Wood	Paper
Sales
$50 X 100,000 (transfer)	$5,000,000
$120 X 100,000		$12,000,000
Variable costs
$20 X 100,000	2,000,000
$50 X 100,000 (transfer)		5,000,000
$30 X 100,000 (processing)		3,000,000
Fixed costs	2,000,000	4,000,000
Operating profit	$1,000,000	$0
Total company operating profit	$1,000,000

Alternative 2: Require Internal Transfer at Transfer Price of $60 per unit
	Wood	Paper
Sales
$60 X 100,000 (transfer)	$6,000,000
$120 X 100,000		$12,000,000
Variable costs
$20 X 100,000	2,000,000
$60 X 100,000 (transfer)		6,000,000
$30 X 100,000 (processing)		3,000,000
Fixed costs	2,000,000	4,000,000
Operating profit	$2,000,000	($1,000,000)
Total company operating profit	$1,000,000

         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.

Alternative 3: Require Internal Transfer at Transfer Price of $50 per Unit Wood
	Wood	Paper
Sales
$60 X 100,000          (grade A market)	$6,000,000
$120 X 100,000		$12,000,000
Variable costs
$20 X 100,000	2,000,000
$50 X 100,000         (grade B market)		5,000,000
$30 X 100,000 (processing)		3,000,000
Fixed costs	2,000,000	4,000,000
Operating profit	$1,000,000	$0
Total company operating profit	$2,000,000

         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 subordinate managers.

           CASE 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.
         To understand the analysis, pick any price higher than the variable cost in Wood Division and ask whether it can be the optimal  transfer price. If it is, it must lead both division managers to make the correct decision. Because no intermediate market for wood exists, we need to consider only the final (paper) market price. Suppose this price is $120 as it was earlier. If  the transfer price is $50, will both managers choose to transfer the product? We know form the analysis of case 1 that this is the decision the firm prefers. For Paper Division's manager, the transfer will lead t an additional $40 in contribution margin (and divisional profit). This is the $120 in revenue from the sale to the paper market less the $50 transfer paid to Wood Division less the additional $30 variable processing cost.
        What about Wood Division? For each unit transferred, its manager receives another $30 in contribution margin (divisional profit). This is the $50 received as revenue from the Paper Division less the $20 variable production cost. Therefore, both managers have an incentive to transfer the product. A transfer price of $50 will work as long as the external price is $120.