CIMA P2 Syllabus C. Managing Performance Of Organisational Units - Transfer Pricing - Imperfect Market - Notes 2 / 5
Transfer Pricing with an Imperfect External Market
Cost-based approaches to transfer pricing are often used
because in practice the following conditions are common:
There is no external market for the product that is being transferred
Or, there is an external market, but it's imperfect because of the amounts that can be supplied to it or only a limited external demand.
So the external market price is NOT valid
Thus other options are used such as :
Full Cost
This would include fixed & variable costs
Full Cost +
This would include fixed & variable costs + a profit element
Illustration 1: Transfer prices based on full cost
| Division A's Costs | |
|---|---|
| Variable Cost | 8 |
| Fixed Cost | 2 |
| Total Cost (and Transfer Price) | 10 |
The obvious drawback to the transfer price at cost is that A makes no profit on its work, and the manager of Division A would much prefer to sell output on the open market to earn a profit, rather than transfer to B, regardless of whether or not transfers to B would be in the best interests of the company as a whole.
Division A needs a profit on its transfers in order to be motivated to supply B, therefore transfer pricing at cost is inconsistent with the use of a profit centre accounting system.
Transfer prices based on full cost plus
| Division A's Costs | |
|---|---|
| Variable Cost | 8 |
| Fixed Cost | 2 |
| Profit Element (10%) | 1 |
| Total Cost (and Transfer Price) | 11 |
Compared to a transfer price at full cost
A gains some profit at the expense of B.
The transfer price fails on all three criteria (divisional autonomy, performance measurement and corporate profit measurement) for judgment.
Arguably, the transfer price may not give A fair revenue or charge B a reasonable cost, and so their profit performance is distorted. It would certainly be unfair, for example, to compare A's profit with B's profit.
The autonomy of each of the divisional managers is under threat as the profit element is made up - and may need to be imposed on them from above
It may give A an incentive to sell more goods externally (if profits are higher there than selling to B)
This may or may not be in the best interests of the company as a whole.