1. Performance Evaluation for Decentralized Operations
LO 5 – Transfer Pricing in a Decentralized Segment of a Business

2. LO 5
Transfer Pricing
When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services.
When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services.

3. LO 5
Transfer Pricing
Three common approaches to setting transfer prices are as follows:
Market price approach
Negotiated price approach
Cost approach
Three approaches to transfer pricing are (1) the market price approach, (2) the negotiated price approach, and (3) the cost price approach.

4. LO 5
Transfer Pricing
Transfer prices can range from as low as the variable cost per unit, to as high as the market price per unit.

5. LO 5
Transfer Pricing
Transfer pricing may be used when decentralized units are organized as cost, profit, or investment centers. We will be using a packaged snack food company (Wilson Company) to illustrate transfer pricing.
Transfer pricing may be used when decentralized units are organized as cost, profit, or investment centers.

6. LO 5
Transfer Pricing
To illustrate transfer pricing, Exhibit 9 presents the income statement for Wilson Company, a packaged snack food company. Wilson has two operating divisions that are organized as investment centers. Exhibit 9 is the condensed income statement, assuming no transfers between divisions.

7. LO 5
Market Price Approach
Using the market price approach, the transfer price is the price at which the product or service transferred could be sold to outside buyers.
The market price approach uses the price at which the product or service could be sold to outside buyers.

8. LO 5
Market Price Approach
Materials used by Wilson Company in producing snack food in the Western Division are currently purchased from an outside supplier at $20 per unit. The same materials are produced by the Eastern Division at the same cost of $20 per unit.
The Western Division of the Wilson Company currently purchases materials from an outside supplier at $20 per unit. The same materials are produced by the Eastern Division at a cost of $20 per unit.

9. LO 5
Market Price Approach
The Eastern Division is operating at full capacity of 50,000 units and can sell all its production to either the Western Division or to outside buyers. The Eastern Division will earn revenues of $20 per unit regardless of who buys the product.
The Eastern Division is operating at full capacity of 50,000 units and can sell its production to either outsiders or the Western Division at $20 per unit. The Eastern Division earns revenues of $20 per unit regardless of who buys the product.

10. LO 5
Market Price Approach
The Western Division will pay $20 per unit for materials (the market price). Thus, the use of the market price as the transfer price is proper.
In this example, the market price of $20 per unit is appropriate because the Western Division would have to pay $20 per unit for the materials regardless of whether it purchases them from the Eastern Division or an outside supplier.

11. LO 5
Transfer Pricing
Wilson’s divisional income statement reports sales of $1,000,000 based upon a selling price of $20 per unit. The Western Division reports variable cost for materials of $20 per unit, which is the cost regardless of whether the division buys from Eastern or an outside supplier. Overall division income is unchanged.

12. Negotiated Price Approach
LO 5
Negotiated Price Approach
The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves on a transfer price.
The only constraint is that the transfer price be less than the market price but greater than the supplying division’s variable costs per unit.
The negotiated price approach allows the managers of decentralized units to agree (negotiate) transfer prices among themselves.

13. Negotiated Price Approach
LO 5
Negotiated Price Approach
Assume that instead of a capacity of 50,000 units, the Eastern Division’s capacity is 70,000 units. The Western Division manager agrees to a transfer price of $15 for the Eastern Division’s product. As can be seen by comparing Exhibit 9 on Slide 11 and Exhibit 10 on slide 14, the income from operations for both divisions would increase $100,000 by this arrangement.
If the Eastern Division’s capacity was 70,000 units instead of 50,000 units, then a negotiated transfer price would be appropriate. When unused capacity exists, income from operations will be increased for both divisions under a negotiated price approach.

14. Negotiated Price Approach
LO 5
Negotiated Price Approach
The Eastern Division charges the Western Division a negotiated price of $15 per unit, allowing it to use up its excess capacity and increase its sales by $300,000. The Western Division is able to reduce materials cost by $5 per unit and therefore decrease its expenses. Overall, the income from operations increases by $200,000. The Eastern Division’s income has increased by $100,000, and the Western Division’s income has also increased by $100,000.

15. Negotiated Price Approach
LO 5
Negotiated Price Approach
Comparison of Exhibits 9 and 10
Income from Operations
20,000 Units Transferred at $15 per Unit (Exhibit 10)
No Units Transferred (Exhibit 9)
Increase (Decrease)
Eastern Division $200,000 $300,000 $100,000
Western Division 100, , ,000
Wilson Company $300,000 $500,000 $200,000
Variable Costs per Unit < Transfer Price < Market Price
$10 < Transfer Price < $20

16. LO 5
Cost Price Approach
Under the cost price approach, cost is used to set transfer prices. A variety of costs may be used in this approach, including the following:
Total product cost per unit
Variable product cost per unit
Under the cost price approach, cost is used to set transfer prices. Cost may refer to either total product cost per unit or variable product cost per unit.

17. LO 5
Cost Price Approach
If total product cost per unit is used, direct materials, direct labor, and factory overhead are included in the transfer price.
If variable product cost per unit is used, the fixed factory overhead cost is excluded from the transfer price.
This approach is appropriate when division managers have responsibility for cost centers.