Negotiated transfer pricing
- Both the buying and selling divisions will participate in the negotiations and are likely to believe they have agreed on the best deal possible.
- Negotiating and determining transfer prices will enhance the autonomy/independence of both divisions.
- The result of a negotiated transfer price between divisions may not be optimal for the firm as a whole and therefore will not be goal congruent.
- The negotiating process may cause harsh feelings and conflicts between divisions.
Using actual full (absorption) manufacturing costs
- The behavioral problems which can arise from using actual full (absorption) manufacturing costs as a transfer price include the following:
- Full-cost transfer pricing is not suitable for a decentralized structure when the autonomous divisions are measured on profitability as the selling unit is unable to realize a profit.
- This method can lead to decisions that are not goal congruent if the buying unit decides to buy outside at a price less than the full cost of the selling unit. If the selling unit is not operating at full capacity, it should reduce the transfer price to the market price if this would allow the recovery of variable costs plus a portion of the fixed costs. This price reduction would optimize over company performance.
Transfer pricing policy
- The behavioral problems that the firm would apply the one transfer pricing policy uniformly to all divisions:
- A change in policy may be interpreted by the divisional managers as an attempt to decrease their freedom to make decisions and reduce their autonomy. This perception could lead to reduce motivation.
- If managers lose control of transfer prices and, thus, some control over profitability they will be unwilling to accept the change to uniform prices.
- Selling divisions will be motivated to sell outside if the transfer price is lower market as this behavior is likely to increase profitability and bonuses.
Standard full manufacturing costs plus a markup
The selling division will be motivated to control costs because any costs over standard cannot be passed on to the buying division and will reduce the profit of the selling division. The buying division may be pleased with this transfer price if the market price is higher. However, if the market price is lower and the buying divisions are forced to take the transfer price, the managers of the buying division will be unhappy.
Market selling price of the product being transferred
This creates a fair and equal chance for the buying and selling divisions to make the most profit they can. It should promote cost control, motivate divisional management, and optimize overall company performance. Since both parties are aware of the market price, there will be no distrust between the parties, and both should be willing to enter into the transaction.
Outlay (out-of-pocket) costs incurred to the point of transfer, plus opportunity costs per unit
This method is the same as market price when there is an established market price and the seller is a at full capacity. At any level below full capacity, the transfer price is the outlay cost only (as there is no opportunity cost), which would approximate the variable costs of the goods being transferred.
Both buyers and sellers should be willing to transfer under this method because the price is the best either party should be able to realize for the product under the circumstances. This method should promote overall goal congruence, motive managers, and optimize overall company profits.