Transfer pricing methods and behaviours - Market cost negoti...

Learning Outcomes

After reading this article, you will be able to:

• Explain the main transfer pricing methods: market price, cost-based, negotiated, and dual pricing.
• Discuss the behavioural consequences of different approaches, including divisional motivation and goal alignment.
• Apply and evaluate each method in practical, exam-relevant scenarios, identifying their strengths, weaknesses, and suitability in varied organisational contexts.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand how transfer pricing methods support divisional performance measurement and impact organisational objectives. Focus your revision on:

• The principles and practical application of transfer pricing within divisionalised structures
• Evaluation of common transfer pricing methods, including market price, cost-based, negotiated, and dual pricing
• The behavioural implications of transfer pricing policy on divisional motivation, conflict, and goal congruence
• Criteria for selecting appropriate transfer pricing methods in different business scenarios

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which transfer pricing method best aligns divisional objectives with group profit where a perfectly competitive external market exists?
   1. Market price
   2. Marginal cost
   3. Negotiated price
   4. Dual pricing

2. True or false? Dual pricing always eliminates all behavioural issues between buying and selling divisions.

3. State two drawbacks of using negotiated transfer prices between divisions.

4. A selling division with no spare capacity supplies goods to another division. What should the minimum transfer price include?

5. Briefly explain why a cost-based transfer price might create inefficiency within divisions.

Introduction

Transfer pricing—the price charged for goods or services exchanged between divisions of the same organisation—is a key area for assessing divisional performance and ensuring goal congruence. The method chosen can influence not only financial results but also managerial behaviour, motivation, and the overall alignment with company objectives.

This article covers the main transfer pricing approaches: market-based, cost-based, negotiated, and dual pricing. It explains their mechanics, strengths and weaknesses, and the typical behavioural responses they provoke in divisional managers. Understanding these is essential for both calculating divisional results and evaluating management decisions in ACCA APM exam scenarios.

Key Term: transfer price
The amount charged when goods or services are transferred between divisions of the same company.

Transfer Pricing Methods

Market-Based Transfer Pricing

Setting the transfer price equal to the price charged in a competitive external market is considered the most objective method when external sales are possible.

• When suitable: A competitive market exists and the selling division could sell all its output externally.
• Effect: Aligns divisional and company interests, promoting goal congruence.

Key Term: market-based transfer price
A transfer price set at the prevailing market price for the transferred goods or services.

Cost-Based Transfer Pricing

Here, the transfer price is based on the production cost of the goods or services. Several variations exist:

• Marginal (variable) cost: Encourages purchasing division to buy internally when there is spare capacity but may demotivate the selling division as it covers only variable costs.
• Full cost: Includes both variable and allocated fixed costs; easier to calculate but may distort performance measures if fixed costs are arbitrary.
• Cost-plus: Adds a mark-up to cost, often to include a profit element for the selling division.

Key Term: cost-based transfer price
A price based on the production cost—variable, full, or with a profit margin—of internally transferred goods or services.

Negotiated Transfer Pricing

Under this approach, divisions negotiate the transfer price, usually within boundaries set by minimum (seller’s marginal cost or opportunity cost) and maximum (buyer’s best external price) prices.

• When used: No easily available market price; divisions have some autonomy and bargaining power.
• Pros/cons: Can improve motivation but may waste management time, encourage inter-divisional conflict, and result in suboptimal outcomes for the group if negotiating skill outweighs rational economic calculation.

Key Term: negotiated transfer price
A price established through discussion and agreement between the buying and selling divisions.

Dual Pricing

This method records the transfer at two different prices for accounting purposes:

• Selling division: Records the transfer at a higher price (e.g., cost plus a profit margin).

• Buying division: Records the purchase at a lower price (e.g., marginal cost).

• The difference is adjusted centrally.

• Purpose: Motivates both divisions by rewarding the seller and reducing the cost for the buyer.

• Drawback: Requires additional accounting effort; can complicate performance reporting.

Key Term: dual pricing
An arrangement where internal transfers are recorded at different prices for the buying and selling divisions, with adjustments made at head office.

Behavioural Implications of Transfer Pricing

Transfer pricing is not simply a calculation—it shapes divisional behaviour:

• Unfair or inflexible pricing can demotivate managers, cause conflict, or result in decisions that are harmful to group profit.
• Over-complex or time-consuming negotiations may divert management from productive activity.
• Inadequate consideration of opportunity cost or external market alternatives can lead to dysfunctional decisions.

Key Term: goal congruence
The extent to which the actions and performance targets of different units or managers are aligned with the overall objectives of the company.

Key Term: divisional autonomy
The degree to which division managers have authority to take decisions independently of head office.

Applying Transfer Pricing Methods

Worked Example 1.1

Scenario: Division X makes a component at a variable cost of $12 and total cost $18 per unit. It can sell externally for $20 but has spare capacity. Division Y needs the component and can buy externally for $20.

Required: What is an appropriate transfer price? Explain the effect on divisional performance if X is forced to transfer at marginal cost.

Answer:
The market price ($20) is the logical transfer price since Division X can sell externally at $20. If X sells to Y at marginal cost ($12), it loses out on $8 contribution per unit, leading to demotivation and poor performance reporting for X, even though it benefits Y. Setting the transfer price at $20 aligns divisional and group interests.

Worked Example 1.2

Scenario: Division A has no spare capacity and can sell all output externally at $50. The variable cost is $30. Division B requests units for an internal project.

Required: What is the minimum transfer price A should accept?

Answer:
The minimum is the variable cost ($30) plus the contribution foregone from lost external sales ($50 - $30 = $20). Thus, the minimum transfer price is $50.

Worked Example 1.3

Scenario: Division P and Q negotiate a transfer price. P’s marginal cost is $16, and Q can buy externally at $24. After negotiation, a price of $20 is agreed.

Required: Discuss potential behavioural and performance impacts of this negotiated price.

Answer:
The negotiated price of $20 benefits both compared to external purchase. However, if negotiation was time-consuming or contentious, the process may damage cooperation or delay decisions. If P lacks motivation due to insufficient recognition of its fixed costs, future performance or relationships may suffer.

Exam Warning

In exam scenarios, always check for external market prices, capacity constraints, and opportunity costs before recommending or calculating a transfer price. Failing to consider these can lead to wrong conclusions about group profit maximisation.

Revision Tip

When asked to evaluate a transfer pricing system, always link your evaluation to alignment with company objectives (goal congruence) and the likely behaviour of managers—will they act in the interests of both their division and the wider group?

Summary

• Market-based, cost-based, negotiated, and dual pricing methods each have distinct uses and drawbacks.
• The most appropriate method depends on market conditions, divisional autonomy, capacity, and the importance of maintaining motivation and fairness.
• Transfer pricing not only affects reported results but also shapes managerial behaviour and group performance.
• Dual pricing can resolve some conflicts but increases central administrative work.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the purpose and main features of transfer pricing in divisionalised organisations
• Distinguish between market-based, cost-based, negotiated, and dual pricing methods
• Analyse capacity and opportunity cost when setting minimum transfer prices
• Identify behavioural impacts of different transfer pricing methods on divisional managers
• Apply methods to exam-style scenarios involving both financial and motivational factors
• Evaluate which method best promotes goal congruence and divisional autonomy

Key Terms and Concepts

• transfer price
• market-based transfer price
• cost-based transfer price
• negotiated transfer price
• dual pricing
• goal congruence
• divisional autonomy