MODULE 3:

RESPONSIBILITY ACCOUNTING AND TRANSFER

PRICING

CENTRALIZATION AND DECENTRALIZATION

Centralization is said to be a process where the concentration of decision making

is in one or on a few hands. All the important decisions and actions at the lower level
are subject to the approval of the president or top management.

Decentralization is a systematic delegation of authority at all levels of

management and in all of the organization. In a decentralization concern, authority is
retained by the top management for taking major decisions and framing policies
concerning the whole organization. The rest of the authority may be delegated to the
middle level and lower level of management.

Advantages/Benefits of Decentralization:
1. Top management is relieved of the usual everyday problem solving encountered
in operating the business and is left free to concentrate on strategy, on higher
level decision making, and coordinating activities.
2. Delegating decision-making authority to lower-level managers enables them to
quickly respond to customers.
3. Decentralization provides lower level managers with necessary experience in
making decisions.
4. Lower level managers generally have more detailed and up to date information
about local conditions than top managers. Therefore the decisions of lower level
management are often based on better information.
5. Added responsibility and decision making authority often result in increased job
satisfaction.
6. It is difficult to evaluate a manager's performance if the manager is not given
much latitude in what he or she can do.

Disadvantages of Decentralization:

1. “Lower level managers may make decisions without fully understanding the "big
picture."
2. In a truly decentralized organization, there may be a lack of coordination among
autonomous managers.
3. Lower-level managers may have objectives that are different from the objectives
of the entire organization.
4. In a strongly decentralized organization, it may be more difficult to effectively
spread innovative ideas.

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RESPONSIBILITY ACCOUNTING

Decentralized organizations are divided into smaller units, each of which is assigned
particular responsibilities. These units are called by various names such as divisions,
segments, business units, centers and departments. Each department is comprised of
individuals who are responsible for particular tasks or managerial functions. Goal
congruence results when the managers of an organization should ensure that the
people in each department are striving toward the same overall goals set by top
management. Hence, decentralization leads naturally to the need to evaluate subunits
and their managers to ensure goal congruence.

Responsibility Accounting is one of the techniques used by management to

evaluate such performance. It refers to the various concepts and tools used by
managerial accountants to measure the performance of people and departments to
foster goal congruence.

Responsibility centers

Ø an organizational unit for which a manager is made responsible.

Examples: A specific store in a chain of grocery stores.

The sales department of a manufacturer or its production department.
The payroll data processing center within a firm.

Attributes of a responsibility center

Ø Headed by a manager that is responsible for the operations of its division;
Ø It is like a small business where the manager is asked to run that small business
and preserve the interests of the larger organization;
Ø Goals for the center should be specific and measurable; and
Ø Should promote the long term interests of the organization and should be
compatible with other responsibility center activities.

Categories of Responsibility Centers

1. Cost center—an organizational subunit where a manager is held responsible

only for costs and the segment manager has control over the incurrence of
costs. The managers are usually expected to minimize the costs while providing
the level of services or the amount of products demanded by the other parts of
the organization. An example of a cost center is the maintenance department of
a manufacturing firm wherein, this department renders maintenance services to
the different producing and service departments of the firm.

2. Revenue center—an organizational subunit where a manager is held

accountable only for revenues. The revenue center manager has control or
influence in generating revenue but not costs since all materials and services
needed to earn the revenue are provided by service centers. Examples: sales
division of a textile company, rooms department and food-and-beverages
department of a hotel are its revenue centers.

3. Profit center—an organizational subunit where a manager is responsible and

has control over revenues and costs. The center incurs its own cost to
generate its revenues. Although the center generates revenue, like a cost

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 center, a profit center generally does not have control over investment funds. A
profit center’s objective is not only to minimize costs but also to maximize
profits. The objective of a profit center is basically the same as the objective of
the company as a whole, that is why it is called as a business within a business.
Examples: Company-owned restaurant in a fast-food chain, Teen’s Department
of an RTW Company.

4. Investment center—an organizational subunit (often a division) where a

manager is accountable for profits and the invested capital used by the subunit.
Examples: A division of a large corporation, leasing subsidiaries, real estate
development, brokerage services, and insurance units of a bank.

Performance Evaluation of Responsibility Centers

Performance reports should contain information only about the costs, revenues,
and resources that managers can control. These reports allow comparisons between
actual performance and budget expectations. The content and format of a performance
report depend on the nature of the responsibility center. The techniques used in
measuring manager’s performance are presented below:

(Figure 2)

RESPONSIBILITY
CENTER EVALUATION TECHNIQUE
Cost Center Cost variance analysis
Revenue Center Revenue Variance analysis
Profit Center Segment margin analysis
Investment center ROI,EVA, Residual income

Measuring the Performance of Cost Centers using Cost Variance

Analysis

The performance of a cost center can be evaluated by comparing its actual costs
against a budgeted or a standard amount. The resulting variances between actual costs
and the flexible budget can be further examined by using standard costing to compute
specific variances for direct materials, direct labor, and overhead.

Cost center managers should only be held responsible for those aspects of
performance that he or she can control to have a fair evaluation of the department’s
performance.

Controllable costs are expenses that an entity has the power to change. Many
business costs are controllable to some extent, such as payroll and materials. Relative
costs are expenses that change depending on where the company does business, such
as the costs of transporting goods.

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 Direct/Traceable costs are costs that can be specifically identified to a certain
responsibility center. These can be traced directly to a cost object such as a product or
a department. These are usually controllable.

Indirect/Allocated costs on the other hand are composed mostly of costs that
are merely allocated to the different responsibility centers, therefore, these costs are
non-controllable by the manager of the division or segment to which the cost is
allocated.

For example, if a company produces artisan furniture, the cost of the wood and
the cost of the craftsperson are direct costs—they are clearly traceable to the
production department and to each item produced—no allocation was needed. On the
other hand, the rent of the building that houses the production area, warehouse, and
office is not a direct cost of either the production department or the items produced.
The rent is an indirect cost—an indirect cost of operating the production department
and an indirect cost of crafting the product which therefore is allocated.

The following is an example of a Cost Department Manager’s report:

(Figure 3)

ABC Company
Performance Report - Department Manager 2
June 30, 2014

(in thousands)
Controllable Costs: ACTUAL BUDGET VARIANCE: (F)/U
Cost center 1 P 1,320 P 1,300 P 20
Cost center 2 835 830 5
Cost center 3 655 670 (15)
Direct Materials 1,200 1,300 (100)
Direct Labor 990 975 15
Indirect Materials 430 400 30
Factory Supplies 26 24 2
Electricity and Water 40 37 3
Telecommunications 35 30 5
Repairs and Maintenance 25 16 9
Supervisor's salary 102 104 (2)
Miscellaneous Expense 47 52 (5)
Total Controllable Costs P 5,705 P 5,738 P (33)
Non-Controllable Costs:
Manager's salary 75 80 (5)
Depreciation Expense 93 89 4
Rent expense 25 20 5
Allocated costs 65 65 -
Total non-controllable costs P 258 P 254 P 4

TOTAL COSTS P 5,963 5,992 (29)

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 Differences between the actual and the budget amount are called variances and
these are identified as either FAVORABLE (F) or UNFAVORABLE (U). Unfavorable
variances indicate excessive costs and should be avoided while favorable variances
mean savings on the part of the division, however, should also be investigated like
unfavorable variances.

Measuring the Performance of Revenue Centers using Revenue

Variance Analysis

A revenue center manager has control or influence in generating revenue but not
costs. His performance should be focused in getting the variances between actual
revenue and budgeted revenue. Performance evaluation of a revenue center is
somewhat similar to the evaluation report of a cost center since it also uses variance
analysis. When the actual revenue is greater than budgeted revenue, there is favorable
revenue variance and vice versa. Unfavorable variances should always be avoided.

Measuring the Performance of Profit Centers using Segmented

Income Statements

Profit centers are evaluated based on income (revenues minus expenses). However,
how the income is measured is important for evaluation purposes. A manager’s
performance is often evaluated based on the profit of the organizational unit or
segment that he or she controls.

Segmented Income Statements

ü A segment is a subunit of an organization and can be a division, product line,

sales territory, or plant.

ü Segmented reporting is the process of preparing financial performance

reports for segments within a firm.

Segment reports can be prepared for any level of the organization: division, product
line, plants within a division, and so on. Segmented reports prepared using variable
costing produce better evaluations and decisions than those prepared on an absorption-
costing basis. In this chapter, segmented reports are prepared using variable costing.

Segmented statements present the results of operations for the whole company and
for each individual segment or center. It can be prepared for activity at many different
levels in an organization. There are two keys to building segmented income statements:

Ø A contribution format should be used because it separates fixed from

variable costs and it enables the calculation of a contribution margin.
Ø Direct/Traceable fixed costs should be separated from common/allocated
fixed costs to enable the calculation of a segment margin.

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A comparison of the formats for a variable-costing income statement and a segmented
income statement using variable follows:
Variable-Costing Income Statement: Variable-Costing Segmented Income
Statement

Sales Sales
Less: Variable expenses Less: Variable expenses:
Variable cost of goods sold Variable cost of goods sold
Variable selling and administrative Variable selling & administrative
Contribution margin Contribution margin
Less: Direct fixed expenses:
Direct fixed overhead
Less: Fixed expenses: Direct selling and administrative
Fixed overhead Segment margin(or Product margin)
Fixed selling and administrative Less:Common fixed expenses:
Common fixed overhead
Common selling & administrative
Net income Net income

Illustration:

Omsta Company produces and sells only two products that are referred to as
RIPS and PITS. Production is “For order” only, and no finished goods inventories are
maintained; work-in-process inventories are negligible. The following data have been
extracted relating to last month:
RIPS PITS
Sales ...................................... P180,000 P180,000
Manufacturing costs:
Materials .............................. 18,000 24,000
Labor ................................... 54,000 48,000
Overhead ............................. 72,000 84,000
Selling expenses ...................... 14,400 10,080
Administrative expenses ........... 12,000 18,000

An analysis has been made of the manufacturing overhead. Although the items
listed above are traceable to the products, P36,000 of the overhead assigned to RIPS
and P72,000 of that assigned to PITS is fixed. The balance of the overhead is variable.

ü Selling expenses consist entirely of commissions paid as a percentage of sales.

Direct labor is completely variable.

ü Administrative expenses in the data above are fixed and cannot be traced to the
products but have been arbitrarily allocated to the products.

Required:
Prepare a segmented income statement using the contribution approach, in total and
for the two products.

The segmented income statement of the two profit centers of Omsta Company under
the contribution margin approach will be as follows:

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 Total RIPS PITS
Sales ...................................... P360,000 P180,000 P180,000
Less variable expenses:
Materials .............................. 42,000 18,000 24,000
Labor ................................... 102,000 54,000 48,000
Manufacturing overhead ......... 48,000 36,000 12,000
Selling expense ..................... 24,480 14,400 10,080
Total variable expenses............. 216,480 122,400 94,080
Contribution margin ................. 143,520 57,600 85,920
Less:direct fixed expenses:
Manufacturing overhead ......... 108,000 36,000 72,000
Segment margin ...................... 35,520 P 21,600 P 13,920
Less: common fixed expense:
Administrative expense .......... 30,000
Net operating income ............... P 5,520

RIPS registers the better performance in terms of peso amount since it has generated a
higher segment margin amounting to P21,600 and a margin return on sales of 12%
(i.e., P21,600/180,000).

NOTE: If the segmented income statement is used to evaluate a manager’s

performance, care is taken to highlight costs that are controllable by the manager.
Holding an individual responsible for costs that he/she cannot change decreases the
chance that the report will be a positive motivator.

Measuring the Performance of Investment Centers

Because the managers of investment centers control resources and invest in

assets, the evaluation of an investment center’s performance requires more than a
comparison of controllable revenues and costs with budgeted amounts. Other
performance measures must be used to hold the managers accountable for the
revenues, costs, and the capital investments they specifically control. Traditionally, the
most common performance measure that takes into account both operating income and
the assets invested to earn that income is the Return on Investment (ROI). The basic
formula for this performance measure is:

[1] ROI = Operating Income ÷ Assets Invested

[2] ROI = Sales margin X Capital turnover

There are really two components of ROI: sales margin and capital turnover.

1. Sales margin — is the amount of profit generated by each peso of sales.

Computed as: Sales margin = Income ÷ Sales revenue

2. Capital turnover — is the number of sales peso produced by every peso of

invested capital.
Computed as: Capital turnover = Sales revenue ÷ Invested capital

The two components are multiplied by each other (i.e., sales margin x capital

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 turnover) and the sales component will cancel out, leaving income ÷ invested
capital.

ROI captures the interrelationships of both elements, as both are needed for a
successful operation.

Illustration:

The following data pertain to the one of Crew Corporation’s division:

Income P 8,000,000
Sales revenue 40,000,000
Average invested capital 50,000,000
Desired minimum return or imputed rate 12%

Required:
Calculate the division’s:
[1] sales margin
[2] capital turnover
[3] return on investment

Solutions:
[1] Sales margin: P8,000,000 ÷ P40,000,000 = 20%

[2] Capital turnover: P40,000,000 ÷ P50,000,000 = 0.8

[3] Return on investment: P8,000,000 ÷ P50,000,000 = 16%

A. Managers strive to increase ROI.

§ Sales margin can be increased by increasing income. This can be

accomplished by increasing sales prices (and more than offsetting a possible
decrease in demand) or by decreasing expenses.
§ Capital turnover can be increased by increasing total sales revenue or
decreasing invested capital (the latter accomplished perhaps by reducing
inventory).

B. ROI measures return in a percentage form rather than in absolute peso, which is
helpful when comparing segments of different sizes.

C. A drawback to using ROI is the potential of decreased goal congruence. For

example, assume that top management desires an ROI of at least 15% (the cost
of capital) and a particular division currently has an ROI of 20%. If a new
project being considered is predicted to have an ROI of 18%, top management
will opt for an “accept” decision. However, since the project would decrease the
division’s present ROI, the division manager may decide to reject the project so
as not to reduce his current ROI rather than to improve overall performance.

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Residual income

Because of the criticisms encountered in using ROI, the Residual Income (RI) model
is developed.

A. Residual income shows the amount of income a given division (or project)
earns in excess of a firm’s minimum goal. This performance measure integrates
the corporate cost of capital as an imputed interest rate and improves goal
congruence. The formula is:

Residual income = Divisional profit - (Divisional invested capital x

Imputed interest rate)

Using the previous illustration: The residual income of the division is computed
as follows

Income P 8,000,000
Less: Minimum income (50,000,000*12%) 6,000,000
Residual Income P2,000,000

B. As long as the residual income of a division or project is a positive amount, the

division is deemed said to be performing well because it increases a manager’s
income pool. Thus, any project that returns more than the cost of capital will be
accepted in accordance with top management’s desire.

C. Since residual income is expressed in absolute peso terms, an analyst forfeits

the ability to compare firms/divisions of differing sizes on a common basis.

D. Both ROI and residual income are useful, but both tools have drawbacks.
Therefore, companies will use a combination of ROI and residual income (as well
as other measures) to evaluate performance.

Economic value added (EVA)

The Economic value added (EVA), which is conceptually similar to residual

income, measures the amount of shareholder wealth being created. It is a more
specific after-tax version of residual income and is computed as follows:

EVA = Investment center after-tax income – minimum income

Where:
minimum income = Investment x Weighted-average cost of capital

The weighted-average cost of capital (WACC) measures the average cost of a

company’s debt and equity capital.

A. The cost of debt capital to a firm is the after-tax cost of interest, after-tax
because interest payments are tax deductible.
B. The cost of equity capital is the rate that a company’s investors could earn on
investments of similar risk.
C. The formula to compute the weighted-average cost of capital is:

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 WACC = (After-tax cost of debt capital x debt ratio) + (Cost of equity
capital x equity ratio)

Illustration:

The following data pertain to Dan Industries:

Weighted Average Cost of Capital (WACC): 10.1%
Before-tax operating income: P35 million
Market value of debt capital: P60 million
Market value of equity capital: P120 million
Income tax rate: 30%
Average total assets
book value: P150 million
current value: P180 million
Total current liabilities: P15 million

Required:
Compute Dan’s economic value added (EVA) using the following investment bases:
1. Market value of long term equity
2. Book value of long term equity
3. Market value of long term assets
4. Book value of long term assets

Solutions:

1. EVA = after tax net income - minimum income (mkt. value of long term
equity * WACC)
EVA = (P35,000,000 x 70%) - [120,000,000 x 10.1%]
EVA = P24,500,000 – 12,120,000
EVA = P12,380,000

2. EVA = after tax net income - minimum income (book value of long term
equity * WACC)
EVA = (P35,000,000 x 70%) - [(150,000,000-15,000,000) x 10.1%]
EVA = P24,500,000 – 13,365,000
EVA = P10,865,000

3. EVA = after tax net income - minimum income (mkt. value of long term
assets * WACC)
EVA = (P35,000,000 x 70%) - [180,000,000 x 10.1%]
EVA = P24,500,000 – 18,180,000
EVA = P6,320,000

4. EVA = after tax net income - minimum income (book value of long term
assets * WACC)
EVA = (P35,000,000 x 70%) - [150,000,000 x 10.1%]
EVA = P24,500,000 – 15,150,000
EVA = P9,350,000

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Transfer Pricing

A problem common to companies creating artificial profit centers is that of

placing a fair exchange of goods and services between segments within the company.
In large corporations, segments of the organization often transfer goods and services to
each other. The price charged between segments is called the transfer price.

A transfer price is the value assigned to goods or services transferred between

segments within the company. The transfer price of interdivisional sales will affect the
selling division’s sales and the buying division’s costs but will not have a direct effect on
the company’s profit. However, the transfer price policy of the company can have an
indirect effect on the company profit by influencing decisions of the division manager.

To the department selling goods and services, the transfer price is its revenue.
To the department buying the goods and services, the transfer price is its cost.
Therefore, transfer prices have a direct bearing on segment margin. Corporate
managers should set transfer pricing policies ensuring that divisions do not purchase
outside when internal facilities with high fixed cost can provide the product. Allowing
these facilities to be idle is detrimental to the overall company.

Desired Qualities of Transfer Pricing Policies

No one transfer price method will be best for all situations. Criteria for a good
transfer price can be reduced to four elements.

1. Goal Congruence. In a decentralized organization, one of the most difficult tasks

is to get everyone to pull toward the common goal – the financial success of the
whole company. Success of each division will not guarantee the optimal success of
the whole company.

2. Performance Evaluation. A transfer price should allow corporate managers to

measure the financial performance of division managers in a fair manner. For
example, if one division sells its entire output to another division, the buyer can
demand concessions from the seller that can cause the seller to appear unprofitable.
If the two divisions are to remain independent, the pricing policy must allow the
seller to get reasonable price for its output.

3. Autonomy. If a division manager must ask for approval for a transfer price from
some higher level, the firm’s policies have diluted the autonomy of its managers. If
autonomy is restricted greatly, the objectives of decentralization are defeated.

4. Administrative Cost. As with all accounting costs, incremental costs should

generate a positive contribution margin. Where internal volume transaction is large
and complex, a more expensive internal pricing system is justified. Administrative
costs also includes waiting for decisions, hours spent haggling, and internal
divisiveness.

Transfer Pricing Schemes

1. Minimum Transfer Price. The minimum transfer price is equal to the differential
costs of the goods being transferred, plus the contribution margin per unit that is
lost to the selling division as a result of giving up outside sales.

11
 It also represents the lower limit since the selling division must receive the total
of variable costs and lost contribution margin to be as well, as if it sold only to
outside customers. The transfer price can be more than this amount but it should
not exceed the purchase price from an outside supplier.

Lost sales on the part of the selling division occurs if there is no excess capacity
since they have to cut their sales to regular customers to meet the demand of the
other division within the company

If the selling division has sufficient idle capacity to meet the demand of another
division without cutting into the sales of its regular customers, then it does not have
an opportunity costs. Hence the lowest acceptable transfer price will be equal to the
differential or variable costs per unit.

From the perspective of a buying division, the maximum acceptable price is

equivalent to the price offered by the outside supplier.

Illustration: (No excess capacity)

Sample Company has several divisions (profit centers). Division A manufactures
Product XY which is one of the raw materials of Division B. Data pertaining to the
two divisions follow:
Division A
Production capacity per month 10,000 u
Variable cost per unit 8.00
Fixed costs per month 70,000.00
Selling price per unit to outside market 20.00
Division B
Purchase price from outside supplier 18.00
Units needed per month 2,000 u

What is the acceptable transfer price between the two divisions?

Solutions:

The Selling Division’s Lowest Acceptable Transfer Price

Transfer Price = Variable cost + Total Contribution Margin on Lost Sales
per unit Number of units transferred

Transfer Price = P8 + (P20-P8) * 2,000

2,000

Transfer Price = P8 + P12

Transfer = P20
Price ====

Therefore, the minimum transfer price for the selling division is P20 while the
buying division can only accept a price of P18. There was no excess capacity if the
company can sell its total production to outsiders.

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 Illustration: (with excess capacity)
Sample Company has several divisions (profit centers). Division A manufactures
Product XY which is one of the raw materials of Division B. Data pertaining to the
two divisions follow:
Division A
Production capacity per month 10,000 u
Variable cost per unit 8.00
Fixed costs per month 70,000.00
Selling price per unit to outside market 20.00
Division B
Purchase price from outside supplier 18.00
Units needed per month 2,000 u
What is the acceptable transfer price between the two divisions assuming sales
to outsiders only amounts to 9,000 units?

Solutions:
The Selling Division’s Lowest Acceptable Transfer Price

Min.Transfer = Variable cost + Total Contribution Margin on Lost Sales

Price per unit Number of units transferred

Transfer Price = P8 + (P20-P8) * 1,000

2,000

Transfer Price = P8 + P6

Min.Transfer = P14
Price ====

Therefore, the minimum transfer price for the selling division is P14 while the
buying division can only accept a price of P18.

2. Market-based Transfer Price

Under this approach, the transfer price is the price at which the goods are sold in
the open market. This method is generally considered the best. It puts both the
buying and selling division managers on an independent basis, provided that they
are free to buy or sell on the outside as well as within the company. By using
market prices to control transfers, all division or segments are able to show profits
for their efforts – not just the final division in the chain of transfers. One difficulty
in using this policy is that outside prices may not exist, or the prices that are
available might not be appropriate.

Considering the same illustrative problem, the selling department’s transfer price
will still be P20 because it is the price at which the product is sold to outside
customers.

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3. Cost-based Transfer Price

A. Differential or Variable Cost Transfer Price

Under this approach, the transfer price is based only on variable or
differential costs. Variable approximates differential costs.

Assuming the same information in the problem, the transfer price in this case
will only be P8 – the variable costs needed to manufacture the product since
there was no increase on fixed costs if transfer of units was made.

B. Full Cost Transfer Price

Full cost includes actual manufacturing costs (variable and fixed) plus
portions of marketing and administrative costs. It leaves no intercompany profits
in inventory to eliminate when preparing consolidated statements. And it allows
simple and adequate end product costing for profit analysis. The primary
problem with an actual full cost is that it gives the selling division no incentive to
control costs. All product costs are transferred to the buying division.

Assume that in the given problem, selling and administrative cost amount to
P2 per unit. If the full cost approach is used for the transfer, the transfer price
will be P17 per unit. This is composed of the variable cost per unit of P8, the
unit fixed cost (P70,000/10,000) of P7 and the selling and administrative cost
per unit of P2.

Full cost transfer price = VC + FC + selling and admin.

P17 = P8 = P7 + P2

C. Full Absorption Cost – based Transfer Price

Many manufacturing companies use full absorption costs basis because of the
difficulty in determining the opportunity cost of making internal transfers to the
company. It must be noted that under absorption costing, only the
manufacturing costs, variable and fixed should be included in this approach.

In this case the transfer price for the product in the example will be P15.
Full absorption-cost transfer price = VC + FC
P15 = P8 + P7

D. Cost Plus Transfer

Some companies use cost plus transfer pricing based on either variable costs
or full absorption costs as a substitute to market prices when intermediate
market prices are not available.

Assume that the company wants a mark-up of 20% based on full absorption
cost, the transfer price will total to P18. The full absorption cost of P15 is
increase by the markup of P3 (P15*20%).

4. Negotiated Transfer Price

This method allows managers to bargain with each other and alleviate some
problems that arise in other methods. A negotiated price is an attempt to simulate
an arm’s length transaction between supplying and buying segment.

14
 Negotiated prices are helpful when cost savings occur from selling and
buying internally. It is also an advantage when additional internal sales fill
previously unused capacity allowing the buyer and the seller to share in incremental
profit.

For any given proposed transfer, the transfer price has both a lower limit
(determined by the situation of the selling division) and an upper limit (determined
by the situation of the buying division). Clearly, if the transfer price is below the
selling division’s cost, a loss will occur and the selling division will refuse to agree to
the transfer. Likewise, if the transfer price is set too high, it would be hard for the
buying division to make profit on the transferred item. The actual transfer price
agreed to by the two division managers can fall anywhere between the lower and
the upper limit. These limits determine the range of acceptable transfer prices – the
range of transfer prices within which the profits of both divisions participating in a
transfer would increase.

Assuming the same illustrative problem, what is the range of acceptable

transfer prices between the two divisions?

The Selling Division’s Lowest Acceptable Transfer Price

Transfer = Variable +
Total Contribution Margin on Lost Sales
Price cost
Number of units transferred
per unit

a. Selling Division with No Idle Capacity

Assuming that the selling division has no idle capacity and is able to sell
all 10,000 units produced to an outside market, the transfer price for Division
A is computed as follows:
Transfer Price > P8 + (P20-P8) * 2,000

2,000

Transfer Price > P8 + P12

Transfer Price > P20

If the selling division has no idle capacity, it is selling all of its units
produced to the outside market at P20 per unit. To fill the order of Division
B, Division A must divert 2,000 units from its regular customers. Thus as far
as division A is concerned, the transfer price must at least cover the revenue
on the lost sales to the outside market which is P20 per unit.

For the part of the buying division, the highest acceptable transfer price
should be the price at which they can buy the product from an outside
supplier. Thus, the buying division’s decision is simple, buy from the inside
supplier if the price is less than the price offered by the outside supplier.
Transfer Price < Cost of buying from outside supplier
< P18

Since the selling division’s lowest acceptable transfer price is P20 it is

impossible to satisfy both divisions and there can be no agreement. This
means that no transfer will take place. From the standpoint of the entire

15
 company, the decision of not having transfers between the two divisions is in
fact more advantageous. There is no point in giving up sales of P20 to save
costs of P18.

b. Selling Division with Idle Capacity

Suppose division A has sufficient idle capacity and is only able to sell
7,000 units to an outside market. That leaves unused capacity of 3,000
units which is more than enough to fill the order of Division B. The desired
transfer price is computed as follows:
Transfer Price > P8 + P0 .

2,000

Transfer Price > P8 + P0

Transfer Price > P8

Since division A has enough idle capacity to cover the order of Division B,
there is no lost sales to outside parties. The lowest acceptable transfer price
as far as Division A is concerned is the variable cost of P8 per unit.

As in the previous case, the highest acceptable price of the buying

division is P18. Combining the requirements of both the selling and the
buying division, the acceptable range of transfer prices in this case is:
P8 < Transfer Price < P18

c. Selling division has some Idle Capacity

Division A sells 9,000 units to its regular customers, thus having 1,000
units idle capacity. On the other hand, Division B must buy all of the 2,000
units required from one source only to be assured of the quality of all the raw
materials. To fill the entire order, Division A must divert 1,000 units of
regular sales to Division B. The acceptable transfer price for Division A is
computed as follows:
Transfer Price > P8 + (P20-P8) * 1,000
2,000
Transfer Price > P8 + P6

Transfer Price > P14

Since Division A does not have enough idle capacity to fill the order of
Division B, there are 1,000 lost outside sales. The desired transfer price for
Division A should cover the variable cost of P8 per unit plus the average
opportunity cost of lost sales amounting to P6.

As before, the buying division would be unwilling to pay more than the
P18 per unit it pays its regular supplier. Thus the range of acceptable prices
is: P14 < Transfer Price < P18

5. Dual Transfer Price

A dual transfer pricing system allows the selling division to sell at a real or
synthetic market price (such as full cost plus a profit percentage). While the

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 transfer price to the buying division is usually the variable cost (plus identifiable
opportunity costs). Use of dual transfer prices is a way of creating a profit and thus
a positive motivation, in both the selling and buying divisions. Such a system,
however, does expand the corporate office accounting task. Intracompany sales
and duplicate profits have to be eliminated before total company profits can be
determined.

In this approach, the selling division may record the transfer at its minimum
acceptable price of P20 while the buying division will record the transfer at its
maximum acceptable price of P18. In this case, an elimination entry needs to be
prepared to compute for total company profit.
Illustration:
Selling Buying Total
Sales P18(elim.) P25 P25
Variable cost ( 8) (18) (elim.) ( 8)
Gross profit P10 P7 P17

Under dual transfer pricing, the sales of the selling division and the cost of the
buying division will be eliminated.

Transfer Pricing For Services

Departments of many large organizations may sell services for customers and
for each other internally. The division performing the services to a second division
generates revenues from such activity. The same transfer is the second division’s
purchase of services. The principles discussed previously can be applied for services.

Multinational Transfer Pricing

The objectives of transfer pricing changes when a multinational corporation is

involved, and the goods and services being transferred crosses international borders.
The objectives of international transfer pricing focus on minimizing taxes, duties and
foreign exchange risks, along with enhancing a company’s competitive position and
improving its relations with foreign governments. Although domestic objectives such as
managerial motivation and divisional autonomy are always important, they often
become secondary when international transfers are involved. Companies will focus
instead on charging a transfer price that will slash its total tax bill or that will
strengthen a foreign subsidiary.

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