Notes Chapter 11A Essay

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COURSE OBJECTIVE E: Learn to make decisions about the future of the organization, using the financial and non-financial tools and information available to you.

Transfer pricing decisions combine the fundamental assumptions about segments, responsibility and evaluation in this chapter on responsibility, with the tools of short-term decision-making and relevant costs from Chapter 12.

A transfer price is needed when one segment of a company provides goods or services to another segment of the same company, and both managers have profit responsibility.

Three general approaches to setting transfer pricing policy:
1. Negotiated
2. Cost (full or variable)
3. Market price

QUOTE TO NOTE: page 466: “…keep in mind that the fundamental objective in setting transfer prices is to motivate the managers to act in the best interests of the overall company.”

Suboptimization occurs when managers do not act in the best interests of the company, although they may be benefiting their own segment.

Negotiated transfer price:

Preserves divisional autonomy (refer to the advantages of decentralization)

Managers have the best knowledge of their own segments.

The managers will only agree to a transfer if the decision results in an increase in profit for both (all involved) managers.

The range of acceptable transfer prices is between the lowest acceptable price to the selling division:
Variable cost
Any opportunity cost resulting from lost outside sales’ contribution margin
Assumption that fixed costs are not affected

And the highest acceptable price for the buying division:
Below the price offered by an outside supplier (if there is an outside supplier).

Capacity issues:

Idle capacity: there is no opportunity cost, because enough capacity exists to product the transferred units without any effect on sales to outside customers.

No (or insufficient) idle capacity: The units can only produced if some outside sales are foregone.

Opportunity cost / unit
= contribution margin foregone on outside sales / number of units transferred

Cost based transfer price:

Using full cost can lead to bad decisions because it considers fixed costs, which are not affected by the decision (see Chapter 12).
Selling segment will never profit from the transferred goods or service.
No incentive for selling division to try to control costs.

Market price as transfer price:

The correct price if the selling price has NO idle capacity, because anything less would result in less profit for both the selling division and the company as a whole.

If idle capacity exists, using this price might result in…