Divisional performance and transfer pricing - Transfer prici...

Learning Outcomes

After reading this article, you will be able to explain the key transfer pricing approaches used in divisional performance measurement, evaluate their suitability, and apply the opportunity cost principle including capacity considerations. You will be able to discuss how transfer pricing affects managerial motivation, divisional autonomy, and group profit, and solve relevant transfer pricing scenarios in line with ACCA PM requirements.

ACCA Performance Management (PM) Syllabus

For ACCA Performance Management (PM), you are required to understand transfer pricing as a tool for divisional performance measurement and its impact on group decision making. Focus your revision on:

• The objectives of a transfer pricing system in divisionalised businesses
• The calculation and application of transfer prices using variable cost, full cost, or market price bases
• The impact of spare or constrained capacity on transfer pricing decisions
• The opportunity cost principle for setting transfer prices and its implications for group profit maximisation
• How different transfer price policies affect divisional autonomy and performance evaluation

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. When does the opportunity cost rule affect the minimum transfer price for internal sales between divisions?
2. What is the key disadvantage of using variable (marginal) cost as the transfer price if the selling division has no spare capacity?
3. Division A can sell its product externally for $30 per unit but incurs $2 variable selling costs on external sales only. What is the minimum transfer price Division A should set for an internal sale if it has no spare capacity?
4. True or false? The overall profit for the group depends on the transfer price chosen between divisions.

Introduction

Divisionalised businesses routinely transfer goods or services between units. Setting the right transfer price is essential, not just for accurate performance evaluation of each division, but also to ensure decisions made by divisional managers lead to maximum group profit. The transfer price chosen can directly influence whether the buying division sources internally or externally, especially when capacity constraints or external markets exist.

Key Term: transfer price
The notional price at which goods or services are transferred between divisions of the same organisation, used for internal accounting and performance measurement.

Key Term: opportunity cost
The benefit forgone by not using a resource in its next best alternative use, often the lost contribution from a sacrificed external sale.

Objectives of a Transfer Pricing System

A good transfer pricing system should:

• Motivate managers to act in the group’s best interests (goal congruence)
• Enable fair assessment of divisional performance
• Preserve divisional autonomy and responsibility for results
• Facilitate accurate recording of internal transfers

If the system fails, divisions may make decisions that benefit themselves but harm total group profit.

Basic Approaches to Transfer Pricing

The three main transfer pricing methods used in practice are:

Market-Based Transfer Price

If there is a genuine external market, the market price provides a “fair” benchmark. Both the selling and buying divisions are incentivised to behave as if they were independent companies. This is usually the optimal price for group profit if capacity is limited and selling costs can be adjusted as appropriate.

Key Term: market-based transfer price
A transfer price set equal to the prevailing external market price, sometimes adjusted to reflect savings on internal transactions.

Cost-Based Transfer Price

Two main options:

• Marginal (Variable) Cost: Only variable cost of production is included. This is suitable if the selling division has spare capacity. However, at this price, the selling division will report no profit on the transfer, which may demotivate its manager.
• Full Cost (Absorption): Includes both variable and apportioned fixed costs. Sometimes a mark-up is added to provide profit to the selling division.

Key Term: full cost transfer price
A transfer price based on total variable and fixed costs as calculated using absorption costing, occasionally plus a standard profit mark-up.

Key Term: marginal cost transfer price
A transfer price based on only the variable (marginal) costs of production for each unit transferred.

The Opportunity Cost Principle and Capacity Considerations

Theoretically, the best transfer price for total group profit is:

Key Term: minimum transfer price rule
Minimum transfer price = variable cost per unit + any opportunity cost to the selling division for transferring internally.

The opportunity cost is determined by whether the selling division is operating at full capacity or has spare capacity.

When the Selling Division Has Spare Capacity

If the selling division can meet all internal demand in addition to external sales, there is no opportunity cost — no contribution is lost. The minimum transfer price is simply the variable cost per unit.

When the Selling Division Has No Spare Capacity

Here, every unit transferred internally means sacrificing an external sale. The opportunity cost equals the contribution foregone on each external unit not sold. The minimum transfer price is therefore:

Variable cost per unit + (external selling price – variable cost per unit – any avoided costs, e.g., selling expenses).

Worked Example 1.1

A division can sell its output externally at $40 per unit. The variable cost of production is $22 per unit, and external sales incur $3 per unit in delivery costs, which are not required for internal transfers. Selling costs are unavoidable.

a) What is the minimum transfer price if the division is working at full capacity? b) What if there is spare capacity?

Answer:
a) At full capacity: Variable cost: $22
Lost contribution: External price ($40) – Variable cost ($22) – Saved delivery cost ($3) = $15
Minimum transfer price = $22 + $15 = $37 per unit

b) With spare capacity: No lost external sale, so no opportunity cost. Minimum transfer price = Variable cost only = $22 per unit

Impact of Transfer Price on Performance Measurement and Group Profit

The transfer price selected moves profit between divisions (affecting their bonus and performance appraisal) but does not change total group profit if all sales and purchases still occur as before. Group profit only suffers if the transfer price causes a buying division to purchase externally when group variable costs would be lower with an internal source, or if the selling division is not motivated to supply.

Exam Warning

Always check if the selling division is at full capacity or not. Using just variable cost as a transfer price when the selling division is already fully utilised may lead to suboptimal decisions and lower group profits.

Market Imperfections and Negotiated Transfer Prices

In practice, external prices may not be available or may fluctuate. Where divisions can negotiate, the transfer price may be set anywhere between minimum (variable cost + opportunity cost) and the maximum price the buying division is willing to pay (usually external purchase price or net marginal revenue from further processing).

Worked Example 1.2

Division S needs a component that costs $45 externally. Division M manufactures the component at a variable cost of $32 per unit. Division M can sell all it produces externally for $47, but external sales require packaging at $2 per unit not needed for internal transfers. M is currently at full capacity.

a) What is the minimum transfer price Division M will accept?

Answer:
Minimum transfer price = Variable cost per unit ($32) + Lost contribution from external sale. External sale contribution per unit = $47 – $32 – $2 = $13. Minimum transfer price = $32 + $13 = $45 per unit.

Summary

Transfer pricing is key in aligning divisional incentives with group profit maximisation. The ideal price depends on the existence of external markets, cost structures, and divisional capacity. The minimum transfer price must always reflect variable cost and, if appropriate, the opportunity cost of lost contribution from external sales. Setting the right policy prevents dysfunctional decisions, supports divisional autonomy, and enables fair performance evaluation.

Key Point Checklist

This article has covered the following key knowledge points:

• The primary objectives of a transfer pricing system in divisionalised organisations
• Different approaches to setting transfer prices: market-based, full cost, and marginal cost
• The opportunity cost principle for transfer pricing
• How capacity affects the minimum transfer price
• The effect of transfer pricing methods on divisional motivation, autonomy, and total group profit
• The importance of considering avoided costs and potential savings on internal transfers

Key Terms and Concepts

• transfer price
• opportunity cost
• market-based transfer price
• full cost transfer price
• marginal cost transfer price
• minimum transfer price rule