Dueling Divisions: A New Dual Transfer Pricing Method

Article excerpt

When an organization's divisions buy and sell goods between themselves, traditional pricing practices have more often pitted divisions against each other than encouraged them to pull together for the greater good. Here's a dual transfer pricing method designed to end the family feud.

A corporation's transfer pricing policy can give its divisions more autonomy while retaining adequate management control. Transfer pricing, or the pricing of products or services supplied by one division to another division, should accomplish three things. It must always result in goal congruence, or guide division managers to take actions not just in their own interests but for the good of the entire organization. It should ease the fundamental tension between decision-making and control. And it should provide essential information so that managers can make suitable, short-run decisions. An appropriate transfer pricing method can motivate division managers and increase the entire organization's profitability.

But because transfer price represents a cost to the buying division and a source of revenue to the selling division, the interests of the division managers always conflict. There has been no shortage of poor decisions made by corporations using traditional transfer pricing methods. Even the dual transfer pricing method introduced several years ago turned out to contain flaws, perhaps explaining why most large corporations still use traditional methods.

No single transfer pricing technique will suit every organization's needs. But for most domestic transfers of products with a fairly developed intermediate market in which the buyer can seek out alternative suppliers, a modified dual transfer pricing method would enable the organization's divisions to make optimal, short-run decisions and to work toward common goals. This article will analyse traditional transfer pricing approaches and the dual transfer pricing technique, and propose a modification of the latter method. It will also present the contusion of a 1990 study of 132 Fortune 500 companies designed to determine how well their transfer pricing methods met the essential criteria for domestic transfers (Figure 1).

Figure 1: Transfer pricing methods used by Fortune 500 companies in
1990

Pricing methods                             Domestic transfer prices
                                              (Percentage of total)

Cost-based transfer prices                             46.2
Market-based transfer prices                           36.7
Negotiated price                                       16.6
Other                                                   0.5
Total of all methods                                  100.0

Source: Tang, Roger Y.W., transfer pricing in the '90s, Management
Accounting, February 1992, pp. 22-26.

Traditional transfer pricing models

Cost-based transfer prices - In transferring goods and services between divisions, organizations use many variations of cost-based transfer prices: actual or standard variable cost, full cost, full cost-plus. To evaluate the effects of these transfers, imagine a completely decentralized corporation with two divisions: Division 1 produces and sells X; Division 2 uses X to make Y.

Variable cost - Assume that company policy requires Division 1 to transfer goods and services at a standard variable cost in order to prevent one division's cost inefficiencies from passing to another (Fig. 2).

Suppose Division 1 has idle capacity and suppose the external price for X is $100. If the transfer price for X is set at the standard variable cost of $55 internally, then that price gives the correct signal to Division 2 to buy from Division 1. The need for goal congruence is satisfied: otherwise, each unit of X-purchased externally by Division 2 would mean a cost of $45 for the entire corporation. The price also gives Division 2's manager adequate cost information for short-run decision-making. …